Beckworth interviews Taylor and Cochrane

Each day my time management spirals more and more out of control.  If only there were 73 hours in a day.  And now there are new “must listen to” podcasts by Tyler Cowen and David Beckworth.  I finally caught up with David’s two most recent offerings. After starting off his podcast series interviewing me, he dug up a couple of obscure economists named John Taylor and John Cochrane.

Not surprisingly, the Taylor interview focused on the Taylor Rule.  I have mixed feelings about this rule.  I do think that something close to the Taylor Rule (not exactly the same) largely explains the Great Moderation.  However, after 2008 I became increasingly disillusioned with this approach, for a couple reasons.  First, it’s hard to know what to do when rates hit zero.  And second, it looks like the equilibrium real interest rate might be more unstable than we had assumed.

I still favor the concept of policy rules, but would prefer an instrument with no zero bound issues, such as Singapore’s exchange rate instrument, or the quantity of base money, or even better, the price of NGDP futures contracts.

For me, the most interesting part of the interview was the discussion of David’s “monetary superpower” theory of the Fed, which Taylor thought had a lot of merit.

The Cochrane interview was focused on the Fiscal Theory of the Price Level, and not surprisingly I have a lot of reservations about this idea, except for countries like Zimbabwe or Venezuela, where it’s clear the fiscal authorities are the dog and the central bank is the tail.  In the US, however, I believe it’s exactly the opposite. Let me respond to a few of Cochrane’s points, and apologize ahead of time if I’ve mischaracterized his views.

1. Cochrane contrasts the FTPL with traditional monetary theories, which imply that a swap of base money for government bonds has important macroeconomic effects. He suggests it’s more like exchanging two fives for a ten dollar bill, just swapping one government liability for another.  But if so, why is it that open market operations (OMOs) clearly do have important macro effects?  The Fed used OMOs to keep inflation close to 2% during the Great Moderation.  Asset markets respond to changes in monetary policy (even before IOR in 2008) in a way that suggests it has powerful effects on the economy.  Global stock indices can move 2%, 3% or even 5% in just minutes after an unexpected quarter point change in the fed funds target.  And until 2008, those changes in the fed funds target merely reflected the impact of OMOs.  So I don’t quite get the FTPL.

2. Cochrane says that in the FTPL the entire future path of government debt matters, not just the current level of debt, and contrasts that with what he calls the M*V = P*Y approach, which (he says) focuses on the current money supply.  But in modern monetary models (market monetarist or New Keynesian) the entire future path of the money supply matters for current prices.

3.  He doesn’t think 30-year T-bonds are currently a good investment, because he’s pessimistic about our future fiscal policies.  And he doesn’t think the Fed would be able to prevent the future inflation that would result from a debt situation that deteriorated sharply.  I’m also pessimistic about our fiscal situation, but believe the Fed can offset the effects of deficits.  Hence I don’t expect much inflation.  My views are consistent with current market expectations, whereas Cochrane seems to have doubts about market efficiency, at least in the case of 30-year T-bonds.

4.  I also read the historical record differently than Cochrane.  I don’t believe the FTPL can explain either the onset of the Great Inflation, or its end.  I don’t believe the common myth that LBJ ran big budget deficits during Vietnam.  I would note that LBJ raised taxes in 1968, and yet inflation continued to rise, because it’s monetary policy that drives inflation.  I also don’t agree with Cochrane’s view that Reaganomics made the deficit situation look better after 1981, because it increased expected future growth. Reaganomics led to much bigger budget deficits, and so if I had believed in the FTPL, I would have forecast higher inflation in 1981, not the much lower inflation we actually got.  Unlike Cochrane, I don’t believe that Reaganomics unleashed a surge in real economic growth, even though I am a fan of Reaganomics, and believe it did lead to higher growth that we would have had under alternative policy regimes.

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To clarify, I believe growth rates in many other developed countries fell below US levels after 1982, precisely because their policies were less neoliberal.  Thus in criticizing Cochrane’s claims about Reaganomics, I’m actually starting from a much more sympathetic position that someone like Paul Krugman.  To summarize, I do not believe that the FTPL offers any explanation for the onset of the Great Inflation, or its end.  Monetary policy clearly explains the onset (base growth rates soared), and can also explain the end with a bit more difficulty (money growth was strong in the early 1980s, as lower inflation led to a one time rise in velocity.)

John Cochrane favors the same sort of market approach to monetary targeting as we MMs favor.  His specific suggestion was something like Robert Hetzel’s 1989 proposal to target TIPS spreads, although you could also use CPI futures prices.  He basically views this as a more sophisticated version of the gold standard, which has always been my view as well.  Unlike Cochrane, however, I believe the CPI is essentially meaningless; it doesn’t track anything meaningful in any economic model.  (No, it’s not the average price at which stuff sells.  The CPI is based on hedonics, which have no role to play in macro.)  Thus I think the most useful definition of the “value of money” is 1/NGDP, that is, the share of nominal output that can be purchased with a dollar bill.  That’s the variable I want stabilized, along a 3% or 4% per capita growth path.  To his credit, Cochrane favors level targeting, and so do I.

Oddly, Cochrane and I end up with fairly similar views on the optimal monetary policy, despite having radically different views on the theory of money.  Indeed I favor having the Fed use OMOs with ordinary T-bonds as a way of stabilizing NGDP futures prices, and as far as I can tell Cochrane doesn’t think OMOs do anything. Unless I’m mistaken, Cochrane thinks the gold standard only worked because central banks promised to buy and sell unlimited amounts of gold at the legal price, or at least something other than T-bonds.  (To head off objections from George Selgin, you don’t need a central bank; private banknote issuers can also assure redeemability into gold.)

In contrast, I believe the central bank could have pegged the price of gold merely using OMOs with Treasuries.  Alternatively, in the 1990s the Fed could have used the Taylor rule without buying any bonds at all.  It was the liquidity effect from monetary injections that caused fed funds rates to change, and hence the Fed could have bought and sold gold or zinc to target fed funds prices, and used that instrument to keep inflation close to 2% via the Taylor Rule. In other words, it’s all about the Fed’s liability (base money); the asset side of the balance sheet hardly matters, at least when not at the zero bound, and hence when OMOs are small in size.

PS.  Over at Econlog, I have a new post discussing a NBER study that is critical of the New Keynesian claim that artificial attempts to raise wages can be expansionary.  Their result supports my claims in The Midas Paradox.

PPS. George Selgin is putting together a very nice series on monetary economics.  The second entry discusses the demand for money, and why the price of money and the price of credit are two entirely different things.



22 Responses to “Beckworth interviews Taylor and Cochrane”

  1. Gravatar of Partisan Partisan
    30. April 2016 at 10:49

    Thanks for this post; I was wondering through the whole podcast what your response to Cochrane would be.

  2. Gravatar of Lawrence D’Anna Lawrence D'Anna
    30. April 2016 at 10:55

    I would love to watch you and John Cochrane debate FTPL.

  3. Gravatar of John Handley John Handley
    30. April 2016 at 10:56

    “Cochrane contrasts the FTPL with traditional monetary theories, which imply that a swap of base money for government bonds has important macroeconomic effects. He suggests it’s more like exchanging two fives for a ten dollar bill, just swapping one government liability for another.”

    I didn’t listen to the podcast, so I may be wrong about this, but, at least in the past, Cochrane has only argued this for when IOR ≈ 3-month treasury yield. (Granted I can’t find the specific example of this that I was thinking of anyway).

    Turning generically to the FTPL, models that exhibit fiscal dominance in price level determination pretty much always require central bank capitulation — i.e. if the fiscal authority commits to be irresponsible then money supply growth must increase to accommodate. See, for example, this textbook chapter:

    The model in question is literally M = PY, but the fiscal authority has ultimate control of inflation if it can specify the path of surpluses before the central bank announces the path of the money supply. Granted, this is more of a fiscal theory of monetary policy than a fiscal theory of the price level, since “fiscal policy can only create inflation in our model because the central bank is forced to increase the money supply, Friedman’s dictum — inflation is always and everywhere a monetary phenomenon — would not seem to be violated here.”

    Thus whether Cochrane is right or you are right depends more on the specific monetary-fiscal regime than what actually determines the price level which is, in both cases, money supply and demand.

  4. Gravatar of ssumner ssumner
    30. April 2016 at 12:20

    Thanks Partisan.

    Lawrence, I did, back around 2010, it’s probably still on the internet somewhere.

    John, You should listen to the podcast. He says OMOs do not explain the price level during the Great Inflation, so it’s clearly not just a model for when IOR equals the T-bill yield.

  5. Gravatar of George Selgin George Selgin
    30. April 2016 at 13:40

    Regarding gold and central banks: my position isn’t that you don’t need a central bank; it’s that a central bank’s commitment to redeem it’s IOUs in gold (or anything else, for that matter) isn’t as credible than an ordinary bank’s commitment to do so. That, at least, has been abundantly clear since the 1930s. It is why CB “pegged” rate systems collapse more often than not, while a commercial bank’s failure to pay its deposits on demand is, even in these days of bailouts and guarantees of other sorts, the stuff of headlines.

  6. Gravatar of Anwer Khan Anwer Khan
    30. April 2016 at 13:43

    John Cochrane always shows his background in asset-pricing (not monetary theory) with a strong focus on discount factors and little to say about liquidity adjustments to his calculations, though he does observe that different forms of government debt are becoming very close substitutes. Indeed the financial system is becoming increasingly better at converting *all* forms of debt into some form of money. This is why I think that the shift in focus to the equation of exchange is an important contribution by monetarists. We really do want to stabilize the growth in expenditure.

    The way that you advocate doing this basically gives up the gives up the goal of price stability, and this entails the costs of weakened price signalling. Indeed you tell us that 1/NGDP is the signal that matters. It is indeed an important signal for intertemporal decisions, but I think we also need a stable and reliable means to compare consumption goods and production inputs. Thus I would advocate the construction of multiple price indices: one home home prices, one for consumer prices, etc. and I would stabilize by writing long-term contracts in terms of these indices. This is the form of risk-management advocated by Robert Shiller.

    At some point in human history, we will need to exploit advances in information technology to reform debt contracts. If not now, then when? After studying the latest recession with micro-data, Amir Sufi and Atif Mian urged us to do it *now*.

  7. Gravatar of Anwer Khan Anwer Khan
    30. April 2016 at 13:52

    In response to George Selgin above: we do need an authoritative publisher of the consumer price index, so that we have a common unit used throughout the marketplace to set prices. The central bank can help us further by producing a really good settlement medium and associated plumbing.

  8. Gravatar of Benjamin Cole Benjamin Cole
    30. April 2016 at 16:44


    In your 72-hour days, you may wish to peruse this:

    There was an interesting “pro” fiscal theory of the price level piece published June 2014 by the Dallas Fed, “Inflation Is Not Always and Everywhere a Monetary Phenomenon” by Antonella Tutino and Carlos E.J.M. Zarazaga

    (you have to scroll to right year and title)

    But there is “the rest to the story”…keep reading please!

    Befitting any tale about inflation, the Weimar Republic is dutifully mentioned, and the Rentesbank solution in th Dallas Fed piece.

    In conclusion the authors state:

    “The fiscal theory of the price level argues that what’s true about hyperinflation is valid more generally: Fiscal policy can prevent inflation from rising or falling too much by backing all outstanding nomi- nal government liabilities—interest bear- ing or not—with a stable level of expected future primary government surpluses. By formally incorporating fiscal policy in the analysis of price-level dynamics, the fiscal theory of the price level is better equipped than the conventional monetarist ap- proach to explain why the recent large expansion of the money supply in the U.S. has not caused higher inflation.
    The theory implies that the quantitative easing programs, which created money to purchase mortgage-backed securities from the public, preserved price stability because that money is backed by the returns from real estate investments. Similarly, Germany restored price stability after its interwar hyperinflation with its real-estate-backed currency.”

    That is fascinating! So when the Fed bought the MBS, they were fighting inflation!

    It also seems to me that monetizing debt, counterintuitively, is anti-inflationary under the FTPL. The government is less indebted, more able to meet obligations.

    Indeed the authors say, “Likewise, any money created to purchase government debt from the public at market prices is backed by the same primary surpluses that the public already expected would service that debt. As long as the expected primary surpluses backing existing government liabilities haven’t changed, there is no reason for the price level to change either.”

    Maybe the authors are onto something.

    I have long wondered when the Fed pays down the national debt, and “gets away with it”–ie not much inflation—if that does not increase the credit-worthiness of remaining debt, and also lower tax burdens into the future. Or, leads to greater government surpluses (relatively).

    I suspect John Cochrane would frown upon the Dallas Fed observation about the FTPL. Many modern-day economists have reservations about QE.

    But political biases aside, QE seems to work.

    I challenge Scot Sumner or John Cochrane to frankly wrestle with the Dallas Fed piece.

  9. Gravatar of Anwer Khan Anwer Khan
    30. April 2016 at 17:22

    Benjamin I’m not sure how Prof. Sumner will respond to your challenge. Remember that he has shifted his focus away from the price level of consumer goods, and his concern is mostly with stabilization of total expenditure. He particularly likes stabilization of labor income. If we just wrote labor contracts against an index of labor prices, that would take us much closer to his goal than we are now. It might even help with the problem of downward nominal rigidity of wages.

  10. Gravatar of Gary Anderson Gary Anderson
    30. April 2016 at 23:25

    Less could go wrong with helicopter money at zero than other things.

  11. Gravatar of Answer Kahn Answer Kahn
    1. May 2016 at 02:09

    I understand and like NGDPLT.

    But QE offers many avenues that have yet to be explored. Scott Sumner has suggested perhaps not seriously the creation of sovereign wealth funds through QE. I have suggested offsetting tax cuts buy QE which in effect is a helicopter drop. This approach is approved by Michael Woodford.

    Another option would be to use QE to create a fund of real estate assets which throw off rents which are placed into the treasury to offset taxes.

    I must confess it seems to me the position of central bankers is taxpayers must suffer along with a suffocated economy!

  12. Gravatar of Michael Byrnes Michael Byrnes
    1. May 2016 at 03:21

    Cochrane did hedge a bit on the CPI targeting idea – his endorsement of targeting the CPI was based on the assumption (which he stated explicitly) that CPI was an accurate measure of inflation. (I was hoping Davis would ask him about a supply shock).

    Also, Cochrane talks about how profligate deficit spending can drive inflation, and he argues that people see an unsustainable fiscal path and devalue accordingly. But couldn’t a monetary mechanism explain this effect? After all, the central bank will eventually be forced to accomodate an unsustainable fiscal path via inflation.

    Isn’t monetary policy by Taylor rule sort of like driving a car by looking only out the rear windshield?

  13. Gravatar of derivs derivs
    1. May 2016 at 03:29

    “My views are consistent with current market expectations, whereas Cochrane seems to have doubts about market efficiency”

    You only see doubts about market efficiency because you see market expectations as a single point. That is not what a market is saying. Need to understand options too. See the distribution and probabilities!!! Markets ALWAYS speak in uncertainty and they even tell you what it believes that uncertainty to be.

    “Thus I think the most useful definition of the “value of money” is 1/NGDP, that is, the share of nominal output that can be purchased with a dollar bill.”

    Yep, I always wonder why no one says that.

  14. Gravatar of ssumner ssumner
    1. May 2016 at 05:35

    George, Good point.

    Anwer, Before we start to measure inflation, economists need to figure out what it is (i.e what is the “price level”). So far they haven’t come up with a good definition.

    Ben, You said:

    “I suspect John Cochrane would frown upon the Dallas Fed observation about the FTPL.”

    This post is my response.

    Anwer, You said:

    “But QE offers many avenues that have yet to be explored. Scott Sumner has suggested perhaps not seriously the creation of sovereign wealth funds through QE.”

    Definitely not seriously.

    Michael, Yes, that’s one criticism, although I suppose the basic approach could also be made forward looking, using inflation expectations.


    You said:

    “You only see doubts about market efficiency because you see market expectations as a single point.”

    I’ve never claimed everyone has the same expectation.

  15. Gravatar of Benjamin Cole Benjamin Cole
    1. May 2016 at 06:32

    Scott: this post does not respond to the 2014 Dallas Fed paper on FTPL. The Fedsters say a central bank buying real-estate backed securities is anti-inflationary. They also say the same thing about capital gains taxes, and presumably progressive income taxes. The paper is an easy read. I just did a post on it over at Marcus Nunes’.

    BTW, I just realized something. We now have a generation of economists and central bankers, in senior positions, who are constantly talking about inflation, despite the fact that inflation has been falling for 30 years in the entire developed world, and we have deflation or very low inflation and very slow growth.

    Put on the BeeGees vinyl.

    PS I do not see what is so bad about a central bank building a sovereign wealth fund. If it works why not?

  16. Gravatar of Gary Anderson Gary Anderson
    1. May 2016 at 07:31

    I read that about the price of money and the price of credit. The price of money is determined by how much people want to hold onto it. The price of credit is determined by the demand people have to buy things on credit.

    See George, I read your stuff!

  17. Gravatar of Anwer Khan Anwer Khan
    1. May 2016 at 07:53

    That is a good point on the difficulty of measuring the price level. I just read an article suggesting that the GDP deflator is more suitable for stabilization purposes:

    and if there is this much dispute about measurement, then perhaps we need to consider alternative strategies. Shiller suggests that we use multiple price levels, and choose the appropriate one when writing a long-term contract. One benefit I see in this is less need for central bank intervention to smooth out the effects of realized risks on these long-term contracts, which Kevin Sheedy used as an justification for NGDP smoothing. And even if the central bank wanted to compensate for incomplete markets by doing such smoothing, it doesn’t have enough instruments to make everyone happy, and what actually happens is that various groups fight over the available lever.

    We have a lot to gain from market completion. Now that banks are exposed so much to housing, they should raise funds by shorting a housing price index. That would be much better than selling off loans packaged in toxic securities that are strongly connected with moral hazard and resulting financial instability.

    Finally, I’d like to point out that you responded to someone posting as “Answer Kahn” who isn’t me.

  18. Gravatar of Benjamin Cole Benjamin Cole
    1. May 2016 at 16:19

    Answer Kahn: that was me. Your name is better than mine anyway. In truth I just goofed. Senior moment. Are you related to Alfred? Or the Star Trek character from India who took over Earth in the 1990s?

  19. Gravatar of Anwer Khan` Anwer Khan`
    1. May 2016 at 17:25

    Benjamin I worry that improper banter could lead to loss of my whitelisted status here. But are we not all cheering for Market Monetarism to take over the Earth?

  20. Gravatar of Benjamin Cole Benjamin Cole
    2. May 2016 at 05:37

    Alfred–do not worry about geeting banned from here. Only one so far, and he was awful.

    I am a Market Monetarist. But there are yet issues to disagree about. What is the NGDPLT—6% annual or 4%? Do we use helicopter drops? How about creating a sovereign wealth fund through QE? When the Fed buys real estate backed securities, is that growth-inducing yet anti-inflationary?

    Lots to get riled up about!

    I am not a Market Monetarist if the goal is 4% growth in NGDPLT.

    I fear my fellow Market Monetarists are not bold enough.

  21. Gravatar of ssumner ssumner
    2. May 2016 at 15:54

    Anwer, Yes, the GDP deflator’s probably less bad than the CPI—but I’d just stick to NGDP, and let the private sector hedge price level risk if they want to (I don’t think they’d want to very often.)

  22. Gravatar of Anwer Khan Anwer Khan
    2. May 2016 at 22:03

    You have a point that some ideas simply don’t pass the market test. Robert Shiller did try to establish house price futures markets but they didn’t really take off, even though banks could really use them to hedge their massive exposure to real estate. But I wonder if he had a great idea that simply needs to be promoted more effectively. You also developed those NGDP futures markets overseas that we aren’t allowed to trade over here for some reason. Securities like that really would be useful to us as exchange medium and unit of account. Indeed Kevin Sheedy showed in his paper that the whole point of Market Monetarism is that we don’t write contracts based on NGDP and need some way to compensate for that missing market.

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