Neat. Even back in 1990, we were worrying about "what is money nowadays", so I guess every theory has to deal with that. I know I always start by thinking about an economy just with gold coins, and go on from there.
For me, FTPL sprung from the same "what is money" questions posed during my graduate school in the early 1980s. Clearly, we needed a theory of the price level that could work in the limit of immense interest-paying liquid inside moneys.
One hopes Cochrane is aware that Warsh is economically and mathematically ignorant. Evidenced by the Hoover transcript of Warsh's comments at the Hoover conference celebrating John Taylor: "The inflation rate, that is, the second- and third-order consequence of changes in prices, not the first-order change in the price level, is up to the world’s central banks." Anyone who passed high school knows that the inflation rate is precisely \Delta price/\Delta time, a pure first order effect. The second order effect is of course the acceleration/deceleration of inflation. Yes, if I had a perturbation theory model for the price level there would in principle be successive terms of increasing order, but only the first term is the inflation rate. To any competent scientist the idea that "the first-order change in the price level, is up to the world’s central banks." is ludicrous. The first order change is precisely what at any point in time the amount of money buyers exchange with sellers for real goods or services. If for instance the government credits people with new money in their accounts when the supply of goods and services is restricted then prices rise, regardless of what the central bank does because people don't have to borrow in the markets to cover the gap between their income and spending. Of course people could choose not to spend even with the government credit in their accounts and prices would fall. The economy of a developed country is ca. >80% wants not needs making changes in human wants the dominant factor economically. Some people drink water from the faucet, some drink $12 coffee drinks. Water is a human need, coffee is a human want. If somehow everyone decided to live like the historical Jesus the price level would collapse no matter what the central bank did with rates. Monetary policy could only work close to an economic control variable if all financing occurred via. bank loans from member banks (and even then it is not simple, take the limiting cases of a single private bank vs. millions of banks and work through the coupled equations). But that is not the world we live in, with global financial capital markets and plethora of financing vehicles. Rough estimates I have seen indicate daily currency transactions around the developed world are of the order of $10^13, the same order as the US yearly GDP. The financial world is massively interconnected and therefore very complex. Anyone, like Warsh, who claims the price level is simple and controlled by central banks (which banks?) is divorced from reality.
John, nice explanation of first and second order and third order CHANGES! A mathematical explanation for Chairman Marsh. First-order effects can be represented by derivatives, while second-order effects involve second derivatives. Graphical Interpretation: First-order effects show slope, while second-order effects indicate concavity of functions. As an aside. I managed risk for hedge funds and later Merrill Lynch. Derivative deltas, gammas and fractal dimensions were calculated and monitored in nearly continuous real time for portfolio's comprised of futures, options and underlying assets. The complexity was daunting.
I believe that Warsh slightly garbled what he was trying to say, and by the first-order effect he meant the price level, so the second-order effect would be inflation (the first derivative of the price level) and the third-order effect would be the change in inflation (the second derivative of the price level). I don't think that's a reason to claim that he is "economically and mathematically ignorant." Based on what I have seen, he probably has greater economic knowledge than you.
Under a floating exchange rate, the central bank is does in fact have a large degree of control over the evolution of the price level. Persistent deviations greater than 2 or 3 percentage points from a target rate of inflation usually result from central bank policies, and much less often from nonmonetary factors such as a pandemic or a sudden reduction in world energy supplies. Compare Switzerland versus the United States versus Turkey for what difference central banks' actions have on the price level both over periods of just a few years and over a generation or more.
BY 2032 (pick your date) the US is belly up due to budget deficits, entitlement spending, social security running out of money, Debt/GDP, incredible fraud everywhere, so on and so forth - it's all tied together.
The market will discount this. There is no way the Treasury interest gets paid what with rising rates, so Mr. Warsh's biggest challenge along with whoever is Treasury Secretary is how to implement yield curve control/financial repression before it all blows and Congress/President face the facts of America's coming debt apocolypse.
Incur an authoritarian's wrath with 2 years remaining in office? The Fed is independent...ostensibly. The chairman and governor's primary concern should (normative) NOT concern themselves with behavior of a petulant child but rather its duties. To wit. Manage interest rates and money supply to influence economic activity. Lender of last resort.
I think we are missing the point about the powers of the Fed. The Fed can make relatively short term decisions, e.g. Paul Volcker’s interest rate increases to stop the inflation of the ‘70s. That took about two years, and with a relatively compliant fiscal policy, inflation ceased to be a major problem until post Covid. Clinton balanced the Budget 4 of his 8 years. Monetary Policy and Fiscal Policy were closely aligned.
But since Clinton, the Budget deficits have been overwhelming. In 2025 we took in $5 T of tax revenues and spent $7 T. And $1 trillion of the expenditures was interest on the Debt.
A balanced budget is impossible for the Executive and Congressional branches to achieve. As a result, inflation is the only way the government will “repay” the debt. Example: if you had purchased a 30 year Treasury in 1996, you would have been repaid in dollars with a purchasing power of half of what the money would have bought 30 years hence.
Since the Treasury’s bond interest rates are driven by inflation expectations (the Taylor Rule) say good bye to a 10 year Treasury less than 4.5%. The huge deficits will be inflationary and interest rates will rise - a vicious circle. And interest rate increases will make investment more problematic.
But there is a solution to paying off our debt by inflated dollars, please let me know.
In half an hour, I'm discussing in Jeff Frieden's lunch group,
Annual Review of Political Science
The Politics of Inflation
Lucy Barnes
Department of Political Science, University College, London, United Kingdom;
I had two thoughts:
1. It would be great if everybody ran their articles through AI asking it to tighten them up, reduce verbosity,
2. How would inflation work in an economy with no cash or checking accounts, just credit cards for everything as the means of payment?
Number 2 is important for revising old-style monetary economics, even tho it isn't literally true.
Number 2 is a main motivation for fiscal theory of the price level. It works even with no cash at all, not even just a cashless limit.
Neat. Even back in 1990, we were worrying about "what is money nowadays", so I guess every theory has to deal with that. I know I always start by thinking about an economy just with gold coins, and go on from there.
For me, FTPL sprung from the same "what is money" questions posed during my graduate school in the early 1980s. Clearly, we needed a theory of the price level that could work in the limit of immense interest-paying liquid inside moneys.
Knut Wicksell addressed point 2 in his 1898 book Interest and Prices.
One hopes Cochrane is aware that Warsh is economically and mathematically ignorant. Evidenced by the Hoover transcript of Warsh's comments at the Hoover conference celebrating John Taylor: "The inflation rate, that is, the second- and third-order consequence of changes in prices, not the first-order change in the price level, is up to the world’s central banks." Anyone who passed high school knows that the inflation rate is precisely \Delta price/\Delta time, a pure first order effect. The second order effect is of course the acceleration/deceleration of inflation. Yes, if I had a perturbation theory model for the price level there would in principle be successive terms of increasing order, but only the first term is the inflation rate. To any competent scientist the idea that "the first-order change in the price level, is up to the world’s central banks." is ludicrous. The first order change is precisely what at any point in time the amount of money buyers exchange with sellers for real goods or services. If for instance the government credits people with new money in their accounts when the supply of goods and services is restricted then prices rise, regardless of what the central bank does because people don't have to borrow in the markets to cover the gap between their income and spending. Of course people could choose not to spend even with the government credit in their accounts and prices would fall. The economy of a developed country is ca. >80% wants not needs making changes in human wants the dominant factor economically. Some people drink water from the faucet, some drink $12 coffee drinks. Water is a human need, coffee is a human want. If somehow everyone decided to live like the historical Jesus the price level would collapse no matter what the central bank did with rates. Monetary policy could only work close to an economic control variable if all financing occurred via. bank loans from member banks (and even then it is not simple, take the limiting cases of a single private bank vs. millions of banks and work through the coupled equations). But that is not the world we live in, with global financial capital markets and plethora of financing vehicles. Rough estimates I have seen indicate daily currency transactions around the developed world are of the order of $10^13, the same order as the US yearly GDP. The financial world is massively interconnected and therefore very complex. Anyone, like Warsh, who claims the price level is simple and controlled by central banks (which banks?) is divorced from reality.
John, nice explanation of first and second order and third order CHANGES! A mathematical explanation for Chairman Marsh. First-order effects can be represented by derivatives, while second-order effects involve second derivatives. Graphical Interpretation: First-order effects show slope, while second-order effects indicate concavity of functions. As an aside. I managed risk for hedge funds and later Merrill Lynch. Derivative deltas, gammas and fractal dimensions were calculated and monitored in nearly continuous real time for portfolio's comprised of futures, options and underlying assets. The complexity was daunting.
I believe that Warsh slightly garbled what he was trying to say, and by the first-order effect he meant the price level, so the second-order effect would be inflation (the first derivative of the price level) and the third-order effect would be the change in inflation (the second derivative of the price level). I don't think that's a reason to claim that he is "economically and mathematically ignorant." Based on what I have seen, he probably has greater economic knowledge than you.
Under a floating exchange rate, the central bank is does in fact have a large degree of control over the evolution of the price level. Persistent deviations greater than 2 or 3 percentage points from a target rate of inflation usually result from central bank policies, and much less often from nonmonetary factors such as a pandemic or a sudden reduction in world energy supplies. Compare Switzerland versus the United States versus Turkey for what difference central banks' actions have on the price level both over periods of just a few years and over a generation or more.
Warsh's Challenges?
BY 2032 (pick your date) the US is belly up due to budget deficits, entitlement spending, social security running out of money, Debt/GDP, incredible fraud everywhere, so on and so forth - it's all tied together.
The market will discount this. There is no way the Treasury interest gets paid what with rising rates, so Mr. Warsh's biggest challenge along with whoever is Treasury Secretary is how to implement yield curve control/financial repression before it all blows and Congress/President face the facts of America's coming debt apocolypse.
John, I ran into the Post pay wall even with your green link, FYI.
Sorry about that. Maybe it was time limited. I'll post here in 30 days.
Incur an authoritarian's wrath with 2 years remaining in office? The Fed is independent...ostensibly. The chairman and governor's primary concern should (normative) NOT concern themselves with behavior of a petulant child but rather its duties. To wit. Manage interest rates and money supply to influence economic activity. Lender of last resort.
As JHC somewhat subtly but brilliantly wrote in this piece, the Fed job is in fact partly political.
Not entirely.
But not zero either.
And of course with the ultimately unsupportable dual mandate, it is even more political than if it had only the single mandate of price stability.
Thanks, John. Will look for it. Poor Kevin.
I think we are missing the point about the powers of the Fed. The Fed can make relatively short term decisions, e.g. Paul Volcker’s interest rate increases to stop the inflation of the ‘70s. That took about two years, and with a relatively compliant fiscal policy, inflation ceased to be a major problem until post Covid. Clinton balanced the Budget 4 of his 8 years. Monetary Policy and Fiscal Policy were closely aligned.
But since Clinton, the Budget deficits have been overwhelming. In 2025 we took in $5 T of tax revenues and spent $7 T. And $1 trillion of the expenditures was interest on the Debt.
A balanced budget is impossible for the Executive and Congressional branches to achieve. As a result, inflation is the only way the government will “repay” the debt. Example: if you had purchased a 30 year Treasury in 1996, you would have been repaid in dollars with a purchasing power of half of what the money would have bought 30 years hence.
Since the Treasury’s bond interest rates are driven by inflation expectations (the Taylor Rule) say good bye to a 10 year Treasury less than 4.5%. The huge deficits will be inflationary and interest rates will rise - a vicious circle. And interest rate increases will make investment more problematic.
But there is a solution to paying off our debt by inflated dollars, please let me know.
“But since Clinton, the Budget deficits have been overwhelming.”
No, the budget deficits the first 6-7 years of W were not overwhelming.
But since 2006 or 2007 or 2008, you are surely correct.
Excellent essay.
Saying a lot without staying all that much of anything.
When did JHC start writing like a (good) politician?