282: A New Theory on What Causes Inflation with Economist John Cochrane
Today, I’m talking to John Cochrane. John is an economist and the Rose-Marie and Jack Anderson Senior Fellow at the Hoover Institution. He’s a former Professor of Finance at the University of Chicago Booth School of Business and the Department of Economics, and the author of the Grumpy Economist blog.
John’s work is focused on monetary policy and the fiscal theory of the price level, and he’s written at length about macroeconomics, health insurance, econometrics, and regulations, to name just a few topics.
In his upcoming book, The Fiscal Theory of the Price Level, he proposes the thesis that government debt is a core driver of inflation, that high interest rates can make deficits worse, and fiscal policy has to come with monetary policy to solve this problem.
In our conversation, John and I talk about why he’s still optimistic about the long-term outlook despite almost always seeing storm clouds on the horizon, why he doesn’t like to use the word capitalism, and how retirees can learn from his research to best protect themselves from rampant inflation in the years to come.
In this podcast interview, you’ll learn:
- How John maintains a positive attitude in the face of what can seem like neverending bad news and idiotic economic policy.
- Why the entrepreneurial spirit of the United States feels more stifled than ever before.
- Why risk management is so important for retirees right now.
- The one thing John would do right now if he were Fed chairman.
- John’s tax strategy advice for anyone looking to future-proof their portfolio.
- Why John thinks the US dollar will continue to be the global currency.
- "Inflating our debt away would make the fundamental fiscal problem worse, not better." - John Cochrane
- "Your investment strategy: don’t put all your eggs on 32 black and spin the wheel. Diversify. Be robust." - John Cochrane
DisclosureOffer valid in the 50 United States and the District of Columbia, to first-time requestors. During the offer period, receive one (1) in-stock book per request. Limit (1) book per week per household. Limit three (3) books total each calendar year, between January 1 and December 31. Offer valid while supplies last. Howard Bailey Financial, Inc. reserves the right to cancel, terminate or modify this offer at any time. Void where restricted or otherwise prohibited.
Casey Weade: Well, John, welcome to the podcast.
John Cochrane: Good morning.
Casey Weade: Well, you're a little earlier than I am right now. So, you're over in California and it's about 10:30 here. So, it's bright and early for you but I take it you're an early riser.
John Cochrane: Yes. Well, at least supposedly.
Casey Weade: Yeah. Well, I'm excited to have someone on the podcast that I've followed for many years along with Larry Kotlikoff, which was a friend of yours, I take it, that ultimately referred you over to us and said, "Hey, if you enjoy this conversation with me, you got to talk to John." And that's what we're doing today. And I said, "Well, I'm going to have to kick off this conversation with the Grumpy Economist blog trying to better understand because, John, you don't seem like the grumpiest guy. And what is it, 7:00 in the morning or something over there? And you should be grumpy, if ever grumpy at this time during the day. So, are you a really grumpy guy? What makes you grumpy?
John Cochrane: No, I'm not a grumpy guy, by and large. My kids gave me that name when one Sunday morning I was reading a Paul Krugman column in The New York Times when one outrage after another and I slammed down my coffee cup and it spilled and they decided to call me The Grumpy Economist.
Casey Weade: Well, I don't think you're alone in that. You know, we speak with many families and we receive a lot of questions from our fans that seem kind of grumpy, right? They're concerned about inflation and interest rates, not just concerned, but as you said, outraged. They're enraged with what's happening in Washington with the government debt and fiscal policy and monetary policy, and that leads to a lot of frustration. And when I consume your information, your write-ups, your talks, I go, "And it doesn't seem all that positive." There's not a lot of positivity that I find in some of those articles. You're out there consuming a lot more information as well than the average individual. You have a better understanding of economics, fiscal monetary policy, and all the different elements that are going on in the world. And that leads you to probably be a little grumpy, I would think. And if that's the case, I want to know, how do you overcome that? How do you move forward? How do you maintain a positive mindset when you do consume a lot of negative information?
John Cochrane: That's good. And as you mentioned, we mixed sort of personal lifestyle ideas along with economic ideas here. It is very important in life to keep a positive attitude and you can get all grumpy when you read a newspaper column you don't like in the morning, but don't let that ruin your day. Life is sweet. And in fact, in terms of economics, yeah, my writing tends to be grumpy because our country could do so much better if only we weren't doing so many idiotic things. It's kind of easier to stamp out idiocy than it is to create new things. And that does tend to make you grumpy. But the big picture is we are still a remarkably great country. Our economy still does remarkably well, given especially of the idiocy it has to forge against. We are, you know, in terms of wealth, productivity, health, long life, and so forth, decline in world poverty. It's actually been a wonderful 20, 30 years. So, yes, there are always storm clouds on the horizon and in fact, that it has been such a great run of 20, 30 years of growth and prosperity leads you to be ever more wishful to preserve this wonderful thing and not let it go under. So, don't be grumpy. Look at the bright side when you appreciate things and get a little bit grumpy and stamp out stupid stuff when you can.
Casey Weade: So, would it be fair to say that you have a negative near to mid-term outlook, but a very positive long-term outlook?
John Cochrane: Oh, I'm both positive and negative about everything. In the near to mid-term, there are problems. We've got a war going on that has to be managed well. Inflation is certainly surging and could lead to a repeat of the 1970s with bouts of inflation. Stagflation could lead to a recession. Things could get a lot worse. There's always dangers out there. The long run is good but should be better. Really, we focus on the short run things, inflation that kind of hit us where it should but really, the tragedy of the US is that in the last half of the 20th century, we were growing about 4% a year and now we're growing 2% a year. And since about 2000, that's not one politician or another. That's just a big slowdown in the overall rate of growth. So, you've got to wait until your grandchildren will be as well off as your children should be. Well, in terms of sort of overall human prosperity, that's really the striking feature, which that's the long run one, and that makes me grumpy too. So, good and bad news at all horizons.
Casey Weade: What I find when I'm visiting with individuals that tend to consume a lot of information, a lot of news articles, a lot of media and a lot of economic reports, et cetera, they tend to become more risk-averse over time due to some of those things that they consume. What impact has this had on you? Have you found that the more you learn year after year, day after day, they become more or less risk-averse? Or do you let it impact your financial life and financial decisions at all?
John Cochrane: No, it doesn't really. I try to stay rational about financial stuff. There is, I think George Will says... I'm a little bit conservative. I mostly call myself a libertarian but a conservative-libertarian. He says, "The art of being conservative is to realize that things could always get worse." And I do think that risk management is the first key to a good investment strategy in the sense of not just how are we going to make a gazillion, but let's think of all the ways in which things could go wrong and at least make sure that we've got those covered. So, a proper amount of risk aversion is appropriate. My hobby is I fly airplanes without engines. I feel like you can't really call me too risk-averse.
Casey Weade: Right.
John Cochrane: And now in a financial sense, I hold mostly equities so I doubt that conventional advice to act in a more risk-averse way as you get older. Maybe that's a mistake too. We'll see.
Casey Weade: Well, when you talk about being grumpy and I think this, you know, I really wanted to ask a question about your biggest frustrations today. But before we talk about what your current big frustrations are with the economy and maybe even deeper than that, let's go back to when you were pounding your fist on the table around that dining room table with your children. So, you're around the table, you're pounding your fist, you're upset. They start calling you grumpy. What was it that had you so worked up at that moment?
John Cochrane: Oh, I forget. It was just some Paul Krugman column. Actually, the original title apparently had some sayings that the children found amusing, so they wanted to call it, I'll put it politely, "Stuff my dad says." But we settled on the grumpy economist.
Casey Weade: Well, that's great. Well, what is your biggest frustration today?
John Cochrane: Okay. I have too many to name one of them at all. In many dimensions of economic policy, America seems to be kidding ourselves. And we do seem to be wrapping ourselves into I think Marc Stein calls us the Republic of Paperwork. It's so hard to get anything built. You know, infrastructure, talk about the infrastructure bill. It's not money. It takes 10 years to get the permits to do anything. And now I'm always going to be hopeful. I notice that even the New York Times has noticed that they want to build windmills but you're not allowed to build windmills because it takes 10 years to get the permits so maybe we'll fix this. You know, it's very hard to build houses. It's just we seem to be an economy sort of stuck in paperwork and not moving forward. Maybe that's the biggest frustration but I got tons of them. I work on debt, addressing that that's a problem. Pretty much any economic issue you look at there's a problem, there's a fairly straightforward solution, even bipartisan one sitting on the table, and we can't seem to get moving on it.
Casey Weade: How do these things impact the way you think about your children? I find a lot of the families that we work with are not as concerned about their own financial future as they are their children or their grandchildren. What are your biggest concerns for your four children?
John Cochrane: Well, not particularly financial. They all seem to be making a living but one always worries. You never stop worrying about your children. So, they're wonderful people and exploring their lives, and you could always celebrate the great things they're doing and worry about them at the same time.
Casey Weade: So, you're able to maintain a positive financial outlook for your children, even though you have some concerns about the future of government policy and kind of where we're headed as an economy?
John Cochrane: Yeah. You know, I want them to live in a vibrant country with many opportunities but I want all of us to live in a vibrant country with many opportunities, and not just the kids of very privileged professors but the kids of people who have come from much harder places.
Casey Weade: Yeah. Well, that's good to hear that we're still positive for our children and our grandchildren. You talk about being not a free market economist and a recent Wall Street Journal article as I was consuming that you talked about being an incentivist economist. So, what is the difference for an incentivist economist? Please define that for us versus a free-market economist.
John Cochrane: Well, I've learned something from the left, which is be very artful with your words and invent new ones all the time. I am a free-market economist, but I think those of us in that area need to be attentive to marketing. And in some sense, like supply-side has a sort of a dated label. And now this isn't just marketing. Free market is an answer. It's not a question. So, what is the question to which free markets is the answer? And one way to wrap it all up in a word is pay attention to people's incentives. And then a lot of government policies fall apart because they don't pay attention to the disincentives. This is the paradox of all policy, means-tested policy, is if you give money so long as people don't work, they end up not taking jobs. Well, there's that disincentive. So, let's pay attention to the incentives. Taxes, the standard way of thinking about taxes is who gets money, who loses money. I like the first and foremost think about the incentives, namely, right now in California, if you're a wealthy person, you earn an extra dollar, you only keep about $0.30 of it. Well, there's a big disincentive, along with an incentive to move to Texas.
So, now in part, who gets money matters. But economists have a lot more to say about the incentives, and that's the part of an economic policy that tends to not get analyzed. Where are the disincentives? Where are the incentives? That leads you to free-market-ism. That leads you to realize that markets are better left alone than run by the government. So, that's an attempt at branding the general philosophy and I like to call myself an empirical free marketer as well. I like adjectives. I learned that from the left as well. But it's important not to be doctrinaire about these things, but instead to keep in mind the weight of evidence in history and logic. But that always tends to lead you back to free markets anyway.
Casey Weade: Yeah. And really talking about the precursor to the free market being the incentive. And I had one of my mentors once told me, he said, "What gets incentivized gets done." And I've lived by that. It's very true in business, and I think it's very true in the economy. Where does capitalism fit in for you? Could you just give us a high-level view? We've got capitalism. We have free-market economists, the free market capital... Just kind of talk about that a little bit if you wouldn't mind.
John Cochrane: Yeah. Well, here we are. We're up in the philosophy department, aren't we? I don't like to use the word "capitalism." I think we know sort of what it means. It is a word invented by Marx, not by Adam Smith and it focuses on capital meaning who owns and runs big factory. You know, think of the big 19th-century factory with smoke belching out of that. So, that's not really the essence of what makes a vibrant opportunity providing a growth-oriented society, especially today. Our businesses actually need surprisingly little capital. They just need, you know, they don't even need a building anymore. They need smart people with computers. And the vibrancy of a society is the economic growth comes down to better ideas to new ways of doing things, new businesses, and new ways of serving people's needs better that usually operates best through markets that are left alone to their own desires. That doesn't have a lot to do with capital in that classic sense. So, it's a fine word, except usually the capitalism, comma, the evils of. So, if you're starting with that, you're starting with a disadvantage. Let's talk about incentives, opportunity, growth, prosperity, and so forth.
Casey Weade: Yeah. Where do you think we're headed? I was having a conversation with our COO the other day. He's working on something for his dissertation, and this is kind of along those lines. He said, "I get a sense that we've lost touch with what made this country great, this entrepreneurial spirit, the spirit of drive and overcoming any obstacles in order to achieve success and create value in the world." Do you feel that the entrepreneurial spirit of this country has shifted and is stifled?
John Cochrane: Is stifled, yes. It is. I tend to resist cultural explanations for things. Now, that doesn't mean culture's unimportant but let's look at the hundred other things that are getting in the way first. So, I think this is still a society full of would-be entrepreneurs. It's just getting harder and harder to be an entrepreneur because it's getting harder and harder to get the permits and to break into the business. It's getting harder to fill out all the forms and have the H.R. compliance department and all the other things it takes to get a business going. And it's not only entrepreneurs in the U.S. There's lots of entrepreneurs around the world who would love to move to the U.S. and start new businesses and hire us and pay our taxes and bail out our government if only we would let them do it. So, I think within our people there is that desire, and still, the U.S. for all our troubles is still the best place to start a business. Things are only worse everywhere else. So, there is some hope there but, yeah, lots of measures of business formation is doing well. People don't move around as much as they used to but I think it's just harder. And part, our government has become quite stifling and that one way of - the big picture is we're becoming a government of permission, not a government of rights.
And one of the crucial features of American democracy was the protection of your right to do stuff. If you own a piece of property, you can do what you want with it. You don't have to plead the City Council for permission to do stuff with it. And well, that leads to a lot of stuff getting done that doesn't get done in a permissioned society, but we're moving much more to a permissions form of government. Well, everything is just getting slowed down and tied up in paperwork.
Casey Weade: Well, I get a sense that that's not going to change. I don't know that we've seen any type of rollback when it comes to regulation roadblocks to economic growth since maybe the 80s. And is that something that can be simplified? We had promises that we would see the tax code get simplified. Didn't see that at all. It only became more complex. It seems like we just continue to make things more and more complex in the US economy and the U.S. government from an IRS perspective, et cetera. Is it possible to actually see some of those things, those barriers break down over time? Do you see that in our future?
John Cochrane: No, I think it is quite... Certainly during the last administration, very quietly under the radar screen where nobody notices and we can get stuff done, there was a lot of regulatory reform. The last economic report of the president that they did kind of outlined a lot of the work they had done, and it was very smart about it, just keep it out of the newspaper so that nobody knows what's going on. Of course, a lot of that got turned around as well. That wasn't very permanent. We have become more and more a government, not even - we used to be a government of laws then we became a government of rules by executive agencies. We don't even do that anymore. Now, we have just executive orders and the first thing every president does is unwinds the last ones, edicts, and puts in new ones, which isn't a good way to run things. But certainly, there's a large crowd waiting for a chance to reform the regulatory state. I think there's a strong legal movement that thinks that this has gone too far. And we still have our democracy. So, when voters get tired of it and want it fixed, it'll get fixed. We had the 1986 tax reform. It's probably long ago for you but I remember it. You can, in a country like ours, sit around, get around the table and say, "Look, you're going to lose your special deduction or use your special deduction but we're all going to come out ahead in the game." It's possible to do that.
Many small countries reform. You know, Sweden, and this was back a while ago, but they turned into a socialist state and then they say, "Hm, it's not working." Fixed that and became quite - they have high taxes but they're quite a free market as far as their economic policies. So, you've got to have hope. I mean, if you're saying it's all going, you're saying democracy is over, let's hope that's not true. So, vote for sensible people and don't vote for dumb people and we still do have a functioning democracy. And when people demand it to get fixed and vote for politicians who will fix it rather than say other stupid things, then it'll get fixed.
Casey Weade: Well, I'm glad...
John Cochrane: That's my hopeful. You wanted optimistic.
Casey Weade: Yes. I was going to say, I'm so glad we kicked this off with grumpy optimism, I might call that. So, that's fantastic. But let's drill down a little bit deeper. And this takes us, I think, perfectly into your new book, The Fiscal Theory of the Price Level, that is set to be published by Princeton in the fall of 2022. Why this topic? Why now?
John Cochrane: Thank you. I was wondering when I get a chance to plug my book, you know.
Casey Weade: Well, and I also want to know by the time fall rolls around, is it going to be too late?
John Cochrane: Well, actually, okay, I will reveal a secret. I'm secretly praying for inflation to keep going through the fall. Sorry. I need to sell some books. Actually, it has nothing to do with the moment. I started working on inflation in 1980. This has been the thing I've worked on academically my whole life. And you know, it just took me that long to write the book. It's not, actually, I have to admit, I'm fascinated by inflation and monetary policy and debts, and I think that's why I wrote the book because that's what I think I have new and good ideas to share with the world on. It's probably not the most important. The most important thing is long-run growth. Never forget. The most important thing in economics is long-run growth, inflation, recessions, business cycles. Nothing else matters but long-run growth. But so, I don't have anything important and new to say about long-run growth. I could just channel my buddy, Chad Jones, here and the other great growth economists. I have something to say about inflation so that's why I wrote a book about inflation. Actually, I turned in the manuscript to Princeton at this introduction, saying, "Well, inflation is stuck at 2%. We haven't seen it for 20 years. Maybe someday it'll come back and someone will care about this book." And then things changed. I got to write a new introduction pronto.
Casey Weade: Yeah. Perfect timing here. Perfect timing, really.
John Cochrane: What a timing.
Casey Weade: Yeah. Well, it's really a new take on inflation, and I really want you to talk about your theory that government debt is a core driver of inflation.
John Cochrane: Yeah, which is I got a new theory and an old theory. So, in terms of the words, the book starts with a quote from Adam Smith. Recognize the basic idea, but it is, so basically, here's the - okay. We're going to get a little nerdy for a minute. Okay.
Casey Weade: Please.
John Cochrane: Where does basically inflation come from? Which is the same question as is, you know, dollars are just pieces of paper. Why do we work so hard for these pieces of paper that cost the government about $0.02 to make them, zero for the government to make the electronic pieces of paper that we work just as hard for? Where's the value? Why do people care so much about this money? Why do we work so hard for a worthless good? And why does it become more worthless, closer to worthless sometimes when we get inflation or deflation? So, it's kind of like the big economic question, and the theory that this book starts with is that fundamentally money is a form of government debt. Government debt is just a promise to print money and give it to you. So, those are all united. Money and government debt are all the same thing. And so, what gives government debt a value? Well, people's expectations that sooner or later it'll get paid off in something worthwhile, that the government will at some point run surpluses in order to be able to pay off its debts. That makes the debts valuable. If you think the government is never going to solve its deficit problems, let me advise you to get rid of your government debt.
How do you get rid of government debt? You buy stuff. Try to buy stuff, you get inflation. So, that shouldn't be too crazy. And I think that idea is in there but that is from an academic point of view that it's a quite different fundamental view. For example, the standard view is that money matters but money relative to government debt. So, does it matter if the government issues more debt and less money, but more money and less debt with the same deficit? Well, I'd say the first order now so that's a sense of how it matters. So, that's the guiding principle and the basic idea of the book.
Casey Weade: So, in layman's terms, I am not an economist, but I would rephrase that and I'm probably going to get this totally wrong, but as this government debt continues to accumulate, the general individuals are going, "Hey, we're never going to pay off that debt." Taxes aren't going to go up so that they can pay off that debt. If that debt is never going to get paid, then why am I going to hold that debt? I'm not going to buy that debt. I'm not going to keep my assets in government debt. I'm going to take those assets and move them somewhere else. I'm going to spend them or I'm going to invest them in different areas of the market, real estate or stocks, etcetera. And that is the core driver of inflation. This lack of confidence that the government debt actually gets paid off in the future makes me want to spend those dollars today.
John Cochrane: Yeah. It's the amount of debt relative to your guess about is it going to get paid off? And so, that's what makes it a difficult theory because when do people lose faith in the government? That's hard to independently measure and it's something you ask me what keeps me up at night. It points to a mechanism that can sort of snowball. It's sort of like a bank. Big inflations are kind of like bank runs. Sort of out of nowhere everyone said, "I see you," and saying, "Well, I don't trust them anymore." I say, "Maybe I don't either." And then we all kind of and then the currency goes and inflation kind of comes out of nowhere as it sometimes seems to come out of nowhere.
Casey Weade: So, is this a fear of default that the average individual has or the institutional investor has to the same degree?
John Cochrane: Yeah. It can either. If you fear either... So, what happens? What happens on our current trajectory? Right now, we have immense debt. As you know, the debt is growing and there is no plan to pay it off and in a couple of years, Social Security, Medicare, and all sorts of other promises that the government has made again. Now, there's the hard choice, either you raise taxes, which is going to be really hard to do or you cut the spending, which is going to be really hard to do or you explicitly default, which could happen even in the U.S. or when the time comes, they simply print more dollars to pay off the current debt, dollars that don't pay interest. Now, if you see that inflation coming in the future, get rid of your government bonds today. That's what rolls it back to that fear about the future rolls it back today. And since our government has short-term debt, you don't really need - your vision doesn't have to be everyone's thinking about 20 years in the future. Really, if you just think, you know, most people hold government debt today hold it for a year or two thinking, "Will there be somebody to roll that debt over?" And once you start worrying about that, then trouble breaks out. The basic view, you know, this is a finance show.
So, what gives a stock its value? Stocks values the present value of future earnings, right? What gives a bond its value? The bond's value is the present value of the future coupon payments and the terminal payoff. What gives government debt its value? The present value of the future surpluses that are used to retire the debt. So, it's really, just take asset pricing 101 and apply that to the government and you come up with that's all the fiscal theory the price level is.
Casey Weade: And would it be fair to say that this is, you know, being a core driver would be synonymous with leading indicator? And that might be the explanation as why we saw an expansion of monetary policy from 2008 until today, but it took 15 years for us to actually see the impact of that.
John Cochrane: I think, no. I think actually monetary policy from 2008 until today wasn't that expansionary. So, yeah, interest rates were low but so was inflation. The QE business I don't think did much good or bad in either direction. Remember what they did is they took treasuries and gave you back reserves. That's what QE is. And I think of that as like I take your quarters and I give you two dimes and a nickel. That's not going to make you spend a whole lot. Fiscal policy was expansive but it was in a period where I think the very low-interest rates of the 2008 to 2020 period helped a lot for the government to finance deficits. As I look at inflation right now, now here's how I put my fiscal theory hat on, I see the immense fiscal and monetary expansion of the last recession. The government, we had $5 trillion of deficit. The total government debt was $17 trillion as of, I think, February 2020 and we printed up about $3 trillion of money and sent people checks. We borrowed another $2 trillion of money and sent people checks. So, that very fast fiscal expansion, that huge deficit I think is the reason that we're seeing inflation right now with only a one-year lag.
Casey Weade: When you're starting to throw out some numbers when it comes to debt and there is a criticism of your work in a recent Wall Street Journal opinion article, I'm sure you saw it. I'm one that can't avoid reading my reviews. Professor Shiva Rajagopal of Columbia Business School said that you're only focusing on the government's 20 trillion and on-balance-sheet debt and overlooking the off-balance-sheet debt of Social Security, Medicare, and Medicaid, arguing that if that was taken into consideration, inflation expectations should be three times higher. What's your response to that?
John Cochrane: Oh, well, and Larry Kotlikoff, who you mentioned earlier, makes this point. Not only does the government have this now 20 some 2, 3 trillion of official debt, it has promised to pay all sorts of things with no ways to pay for them, which is sort of an unofficial debt. Right. That thing's right. Now, I think that didn't particularly get worse in the last year or two and I think that is, in the end, if this turns into sort of the big - a moment has to come of a fiscal reckoning for the US that that's just budget, just the fact of numbers add up. We cannot kick this can down the road forever. And that moment, a lot of that moment is that we've made all these promises that our government has no way of keeping. Now, I'm not sure it's productive to think that of debt as it is different from the on-budget debt. You cannot go down to the Social Security Administration and say, "You guys have no way of raising this money. So, I want mine in a lump sum right now." But you can go to the Treasury and say, "I've got all these Treasury bonds and you guys have no way of raising this money. I want it now." You sell but you can't sell your Social Security. You can't sell your Medicare. You can't - those are not marketable debts.
So, that whole mechanics of I'm going to run away, I got to run. I got to dump those things and drive the price down. That doesn't happen in Social Security debt. I think it's better thought of as a promise to pay that will get resolved. I think, frankly, it's going to get resolved by cutting benefits. That's the way other countries do it when the time comes that you run into a debt crisis. Now, the US, you know, I don't want to, you're heartless, throw grandma off the train. No. I think our social welfare system could be reformed to give people the money who need it a lot more effectively and waste a lot less money. But that's I think, Nana, if you think that's what's going to happen, that's not quite the same mechanics as there's debt that when the Chinese and everybody else dumps our debt, that's a quick problem. That's a different problem than sort of people lose faith that Social Security is going to be there when they retire.
Casey Weade: So, a correlation, but not a direct correlation. And this brings me directly to interest rates. So, can the Fed control inflation by raising interest rates? If the government debt is a direct correlator for inflation, if we raise interest rates, aren't we enhancing the amount of government debt and only furthering inflation?
John Cochrane: Yeah. Yes. So, I do think buried in here, well, not even buried in here, a reevaluation is coming. You know, we take for granted that the Fed is enormously powerful and can control inflation. That's a new idea, that now new. Well, this is a show for people thinking about retirement, for whom 1965 isn't that long ago. But there was a time, even through the 1970s, where people didn't think the Fed had that much to do with inflation at all. Well, now we think, "Oh yeah, higher interest rates, lower interest rates, that's everything." Well, the Fed has limited powers to affect inflation. It does have quite a bit of power to affect inflation but especially when, as you're saying, if the fundamental inflation comes from fiscal policy, then the Fed has limited ability to fix it. As a metaphor, the Fed is about liquidity, right? So, if the car is going too fast down the freeway, fiscal policy is the accelerator stuck to the floor. The Fed can drain some oil out of the car. That'll slow it down. It's not a very effective way to slow it down. And the fundamental problem is still that the accelerator is stuck to the floor. And you said something very deep, which I appreciate because it took me a couple of years to get to that understanding. The Fed's ability to cool the economy by raising interest rates is limited by fiscal policy.
And I'll just draw out what you said. If the Fed raises interest to 5%, my colleague John Taylor of the Taylor Rule says interest rates should be about 9%. You got 7% inflation. You need interest rates higher than inflation in order to tamp down inflation. So, the Fed is going on a forecast that almost all of this inflation is going to go away on its own. It only has to raise interest rates to 2% to 3% for the interest rates to be higher than inflation. No. You know, watch out. The rule is for the Fed to lower inflation. Interest rates have to be higher than inflation. So, if inflation does not mostly go away on its own, we're going to see some big interest rates rise. But will that even work? Getting to the point. If the Fed raises interest rates to 5%, 6%, 7%, 8%, 10%, that raises the interest costs on the debt, and those are big now. That means we have another trillion or more dollars on the deficit then the whole debt problem gets worse. And the debt problem was what's driving the inflation in the first place? So, Brazil has seen this dynamic. If you have an inflation that's being driven by too much deficits and you just raise interest rates, that makes the deficits worse and it can make the inflation worse. So, the Fed... So, I'm up here. I can tell you, I used to be a professor.
For the Fed to lower inflation by raising interest rates, it has to raise interest rates substantially, and we need, at the same time, fiscal policy to contract fiscal policy. You have to pay off the higher interest costs on the debt or you have to convince people that you're going to pay them in the future, which is kind of the whole problem. So, the Fed is limited in its powers in a bunch of ways, and one way is that it's going to need fiscal policy to go with it.
Casey Weade: So, let's have you pull out that crystal ball. What do you expect to see? Right now, you could argue we're seeing pretty dramatic projections from the Fed of what they're going to do with interest rates going from a quarter-point to a half-a-point to one. I mean, those are pretty substantial. That's a 100% increase and more.
John Cochrane: No, they're not. That's 7% inflation.
Casey Weade: Well, exactly.
John Cochrane: Relative to 7% inflation quarter 1 is like, you know, we're goofing around here.
Casey Weade: Yeah. But you say, well, it's a 100% increase in interest rates but that's all relative at the end of the day, right?
John Cochrane: Now, the Fed may be right. This may all go away before they actually have to do anything more than symbolic about it. So, anyway, go ahead.
Casey Weade: Well, what do you envision and take what you envision versus what you would do if you were chairman?
John Cochrane: Thank God I'm not chairman. They're doing a very hard job and I shy away from making forecasts because they tend to be wrong. And I think that's a good advice for all of us. So, this is an advice show to some extent.
Casey Weade: Well, let's digress there for just a moment because there are individuals that are trying to consume this information from economists and economic projections are all over the board, right? Everyone has a different opinion, and some are starkly different than others. How would you guide a retiree or anybody in consuming that information and acting on it?
John Cochrane: Well, I think what you just said is the most important thing. Opinions are all over the board. So, always start with risk management. When opinions are all over the board, that means there is genuine uncertainty about what's going on. That means none of your experts really know. So, the strategy of pick one expert and go with that as if it's absolute certainty is a bad strategy. Recognize that lots of different things could happen and nobody really knows, and you need a robust strategy that's going to keep you through it. Inflation could, well, there's a very clear scenario that we could be just starting off where it's 1972. The Fed has announced a monetary policy that looks exactly like what they did in the 1970s, that they will respond very slowly through inflation. They are behind the 1970s curve. In the 1970s, they actually did raise interest rates much more quickly with inflation than they're doing now. We just had an oil price shock and a little war, hopefully not a big war and kind of the same sort of Washington. We could be heading down or we could not or Powell could be right. This could all just be a one-time price level increase that all melts away and we go back to zero interest rates and fighting deflation. I tend to think that inflation is breaking out, will be more long-lasting, but let's recognize lots of different things can happen. So, your investment strategy, don't put all your eggs on 32 black and spin the wheel.
Casey Weade: Okay.
John Cochrane: Diversify. Be robust.
Casey Weade: Well, I like it that we've chosen one economist here. We're going to run with that. But let's put you in that chair. So, you are now chairman. What do you do today?
John Cochrane: Well, I'm going to squeeze. I got to wiggle out of this one, too. I do think, first of all, I'm going to find out why in the heck did the Fed's inflation, why did the Fed miss this so badly? This is a huge institutional. I mean, the Fed's number one job is to see inflation coming and do something about it, and they were caught totally flatfooted. So, it's clear that their methods for forecasting inflation are... Second, I would not put so much faith in the forecasts going forward. The Fed has done what I have just described. They put all their chips on 32 black. They said, "The forecast is the inflation is going to go away so here's our list of interest rate responses." I think, now, they're starting to say that. I heard some hints in Powell's testimony. If inflation keeps going, we could deviate from this path and start moving faster. But the problem is the inflation that's coming is a joint fiscal and monetary policy. So, it's not just in the Fed's hands.
Casey Weade: Well, when it comes to the stock market, it seems like there's also a divergence in opinions there as well. When it comes to shifts in inflation interest rates, you say, well, the stock market should do well. It should be doing well. That's why inflation is going up. That's why they're also having to raise interest rates. What are your expectations if we do enter an inflationary environment and a rising interest rate environment for a long period of time? What will the impact be on the equity market and the fixed income market?
John Cochrane: Man, the other thing that's even harder to forecast is stocks. You just got to remember the stock market too, the price is set where exactly half of the people think it's going up and half the people think it's going down, and half of them are wrong. I just don't know which half. We can certainly do some if and then. So, we do know that the stock market is sensitive to interest rates. So, if real interest rates rise, that is going to lower the level of the stock market. If the economy tanks, that's going to lower the stock market. Some of the worst years for the stock market were 1974. There wasn't a big crash but it went down 40% in the year. So, stagflation, I think, is something we worry about as much for the inflation itself. I mean, stocks are just supposed to be real assets that maintain their value during inflation, so why did stocks do badly during the time of inflation? Well, I think because correlation versus causation. Inflation is always a time of economic chaos, financial chaos, government chaos. So, stocks do badly in times of economic, financial, and regulatory chaos, not because of the inflation, per se. There's a temptation for governments to fight inflation with very damaging taxes, corporate taxes in particular. That's not good for the stock market with measures that really hurt the economy, that would hurt the stock market.
So, you're not really worried about in stocks which are supposed to be an inflation hedge. It's not so much the inflation itself as the bad policies that are causing inflation and that are going to be used to counterproductively do things about it. I mean, you look at our government and the list of narratives about inflation straight out of the Middle Ages. First, it was the hoarders and then the price gougers and then greed and then the corporations. And then it's all Putin's fault. But I mean, no one's talking about monetary and fiscal policy, which is where inflation comes from. So, there is a great desire to do everything else but what might actually hurt. Sorry. Yes, but stock market. So, higher interest rates will generally bring stock markets down. Now, we're long-term investors, I hope most people listening to us. So, this is one of the big things we learned about the stock market in the last 20 years is it is actually a good deal like the bond market that when prices go down relative to dividends and earnings, there is a tendency for those prices to come back up over like a five-year period. So, if you can afford to hold on, it's really not as much bad news as it sounds, the same way if you're holding a long-term bond and you're holding it until maturity, if the price goes down, the yield goes up. So, in the end, you'll be okay. And there's a similar don't worry about it so much for stock markets if you're a long-term investor.
Casey Weade: Okay. Well, let's head on tax rates before we close this thing up. So, you talked about government debt and assets not having the confidence as a society that are going to see that government debt get paid off. But I've had other guests on that say, "Well, we're going to see a dramatic increase in tax rates in the future because we have to in order to pay down the government debt and continue to fulfill the entitlement programs." So, is your sense that we are not going to see a dramatic increase in taxes in the future or otherwise?
John Cochrane: Yeah. Well, there's this conundrum. We have a European welfare state and tax system doesn't pay for it. We're not as far off as you think because we have federal, state, local, and sales taxes. So, you add all that up, there's actually quite a bit of taxes but not enough to pay for all the benefits. So, where's the money coming from is a good question. I think the economic reality of it is that sharply higher tax rates in the current tax system will not do the trick. If you do the all-in-top marginal tax rate in the state of California is about 60% to 70%, you can't really raise taxes much more than that. So, the idea, we'll just tax the rich or tax the corporations or tax somebody else, there is just not enough money there at tax rates that keep the economy going. So, what does Europe do? Europe has value-added tax. You want to pay for 55% of GDP benefits like France does? You have a 40% payroll tax and a 20% to 25% sales tax on everything. Middle-class taxes for middle-class benefits. That's the way Europe goes. And I think the economic reality is that if America wants that level of benefits, that's the kind of tax it's going to have to have. And we have, you know, a lot of our taxes are implicit in a massively complicated system.
Like, Europe charges taxes and gives you healthcare. We have health insurance, mandatory health insurance, but it's about the same amount of money. So, I think the way to how do you square the circle? You think outside the box. The right answer to this is growth where the government needs tax revenue. It doesn't need taxes. It needs tax revenue. What's the difference? Tax revenue is tax rate times income. So, how do you get more tax revenue? Well, you can try a more tax rate but if you raise the tax rate, people start working, you start working, the economy falls apart, and the income goes down. Maybe not one for one but it's like climbing up a sand dune. Every step up you take, you're going to slip back because every time you raise tax rates in the current system, the economy falls a little bit and you get less revenue out of it. How about let's unleash economic reform and let growth go nuts? So, a growth-oriented reform would give you a lot of tax, a lot of more income, a lot more GDP. And incidentally, even with the same tax rates, you get a lot more revenue. Also, if the economy grows like crazy, a lot less people need the help. People would prefer to work than to receive checks from the government. Well, that's just the right way all around.
So, actually the solution to our taxes, I'm all for a tax reform. We have a tax system that raises remarkably little revenue at very high rates because it's full of Swiss cheese. Hundreds and hundreds of thousands of pages keep tax lawyers and accountants and lobbyists busy all day long. So, definitely, when we face reality, we need to actually lower the marginal rates, broaden the base kind of tax reform, but economic growth is the answer to squaring the circle rather than having a very painful economy-killing period of austerity or throwing grandma off the back of a train with painful benefit cuts.
Casey Weade: So, why control inflation at all? Why not let us inflate our way out of debt?
John Cochrane: Oh, thank you for asking that. Our problems will not be solved. Our problem is not a debt problem. Our problem is, in fact, as Larry Kotlikoff was on the show saying, "It's a no plan for paying off the debt plan." And in fact, our plans are to keep borrowing more and more and more. So, if you default on the debt, which is what inflation does, you do not solve this problem that every year we now have a trillion-dollar deficit. Every crisis we have a $5 trillion stimulus and bailout blowout. And then come Social Security, Medicare. That's all in the future. And so, inflating away or defaulting on our current debt, in fact, makes all that worse because we would lose the capacity to borrow money at all. No one lends you money the day after you welched on your debts. No one lends you money. So, inflating our debt away would make the fundamental fiscal problem worse, not better. You can borrow 100% of GDP as we have if you have a plan to pay it off. You can borrow tremendous amounts of money if you have a good plan to pay it off. Welching on your past debt is not a way to get a plan to pay it off.
Casey Weade: So, you discussed your investment strategy a little bit and talked about taxes. What type of tax strategy do you implement today or the way that you think about investing and saving from a tax perspective in order to safeguard yourself against the risks we may face in the future?
John Cochrane: Yeah. Well, I'm personally nowhere good about this as I should be, but certainly doing wise but not too clever - let's not go to jail, please. Things about taxes is the most important part of an investment, especially a long-run investment strategy. Why? Because it's free. You know, in my life as a finance professor, everyone's all, "Oh, let's find alpha. Let's find the great manager who makes us a lot of money." There's a lot more money to be had by doing things from a sound tax perspective, you know, simple examples. When you sell stuff, you pay capital gains. So, don't sell stuff. Don't pay short-term capital gains. Never sell anything less than a year from when you bought it. You don't know for sure about where it's going, I mean, unless you got really good reasons. That's just a tax efficiency. It's easy to get. Of course, talk to your estate tax lawyer. You know, look, on the margin 50%, that's a huge bite. I referred to the corrupt Swiss cheese of a tax code. Well, you know, they're offering this to you. And I'm not an expert, but you know, you have to understand our tax system. Like so much of America, a fancy word is price discrimination by needless complexity.
Let me unpack that for you. The way things work is that it's like the whole system is like airline frequent flier miles or credit card rewards. If you're willing to take the time and really dig into it, you can save a lot of money, otherwise, they're going to screw you. That's a technical term. And so, taxes are the same way. It's deliberately set up to be complicated and opaque. Why? So that people don't take the time and effort. They take your money. That was sort of more an ode to tax efficiency. You know, the basic principles are do good estate tax planning, so it doesn't all go away when you die. Try not to sell things, avoid capital gains. Those are sort of basics, and I'll leave your tax experts to tell you all the other tips and tricks, but it's sort of the first. The first stage is before we get into what's the next hot idea, risk management wasn't a lot of ideas. Recognize that for every buyer, there's a seller. The average investor holds the market portfolio. We can't all be smarter than average. Half of the people will think they are deluded. So, risk management, second step, don't pay too many taxes. Third step, we can talk about the fun stuff.
Casey Weade: Well, I think we've wrapped this conversation up with the common sense guidance that we're looking for. Let's just skip on over and wrap it up with a question from one of our fans. So, our Weekend Reading subscribers, they submit questions to us prior to our guests coming on the show, and we had a question that I think is very relative to the conversation here today from Tom. And you know, we're going to talk a little bit about this question. I'll read it off and then I'll really show us where to focus and where I think we haven't really touched on yet. Tom says, "Our national debt is a huge elephant in the room that no one seems to be addressing, which you have addressed, and this has me concerned as to the stability of the dollar being used as a world currency. How can I, as an investor, be proactive in dealing with this so that inflation doesn't clobber us all?" I really just want to focus on I think we talked about inflation. We talked about the elephant in the room, but we really haven't talked much about currency. Could you touch on the dollar and currency and maybe even throw some cryptocurrency thoughts in there?
John Cochrane: Okay. You wanted the short answer to that one? So, first of all, if you're an American investor, most of the stuff you buy is in dollars, so you don't care all that much about the currency. And of course, the dollar's relative to everyone else. So, in a sense, I think the event to fear is a global inflation, a global sovereign debt crisis. You know, where's the next bubble coming from? Well, what's the one no one's talking about? Where's there a lot of debt that no one knows how to repay? That's sovereign debts, and that's China's sovereign debts and Europe's sovereign debts, and America's sovereign debt. So, it's not clear we're in worse shape than anyone else and the dollar relative to other things is likely to go down. In fact, usually in times of crisis, the dollar goes up first because people, you know, in other countries are in worse shape than we are. This last recession didn't really work out that way. So, I think there is some beginnings of warning signs that the dollar won't always be the safe haven that in bad times, dollars might go down as well.
But, number one, most of the things you want to buy are in dollars if you're a U.S. consumer. It's not that much of an issue. The dollar being the world's currency it's of limited benefit to you as an investor. It means Uncle Sam gets to borrow, I don't know, maybe another trillion bucks for free but we've already borrowed that so I'm not sure it's an enormous amount of good. I think it's a lot of reason to worry about it. You know, we're using sanctions a lot, and it's like a very powerful weapon right now against Russia. But everyone notices and a lot of people around the world are saying, "Oh, the U.S. government might freeze my accounts. I think I might need accounts somewhere else." So, I think that is in motion but I don't see it as having a first-order effect in sort of the danger of global chaos and inflation, which is still a small, you know, we're talking risk management here. I'm not saying go out and put all your money in gold bars and hide them in the basement but it's a small but substantial risk to worry about.
Casey Weade: So, you believe in a large part, the dollar will remain the global currency?
John Cochrane: I think dollars will remain. There's a danger of an inflation, which is the main danger for you is inflation, whether the dollar is a global currency or not. I don't think the average investor really should care about it. The average investor who has a lot of Swiss francs is doing just fine, thank you, and doesn't care whether Swiss francs are the global currency or not. I do think that that motion is underway. It's kind of puzzling. You know, things can be quoted in dollars but people don't have to hold a lot of dollars. And I think actually we may head that direction because it's very easy to change money, even large amounts of money around. So, I think this is a sort of a nebulous thing that we need to define our terms and have a whole show about if you wanted to. Sorry. Go ahead.
Casey Weade: What role would cryptocurrency play in global currency markets, if any?
John Cochrane: Well, cryptocurrency is a perpetual answer in search of a question. And again, there's like five flavors of cryptocurrency. There's bitcoin, which is a claim to nothing, an attempt to recreate gold. And there's been the stablecoins, which are a way of recreating the money market mutual fund. So, it's nothing really new in economics or finance. There's some interesting new technology. So, what is crypto right now? The main thing it offers is anonymity. And that's actually anonymous. That's sort of the big financial issue. Can you have anonymous transactions? And so, one central component of economic and political and personal freedom is, are you allowed to buy or sell without the government knowing about it or controlling it? And crypto right now, what's the main use for? You want to get money out of Ukraine? Crypto is a good way to do it. You want to get money out of Russia? Crypto is a good way to do it. You want to get money out of China, Venezuela, Argentina? Crypto is a good way to do it. You want to avoid paying taxes? You want to do some ransomware? You want to be a drug runner and get money around? Crypto is a good way to do it.
So, really, that's the use case right now. That's not going to unseat the dollar but I think it has a very important impact. Now, governments are going to try to clamp down on that sort of thing. This is, I think, where do we go with the need for a digital dollar, for digital payments, but to preserve some amount of privacy and right to do what you want. And like the Canadian truckers who found their bank accounts frozen when they mounted a political protest discovered that government-run digital currencies pose some privacy risks. That's a hard night because you want to be able to collect taxes and you want to be able to fight crime, but you also need to maintain some ability to move your money around freely. You want a hard policy problem. That's going to be one to think about and also for you as investors.
Casey Weade: Well, John, I look forward to reading your new book and much more that is on the horizon for you. It's been enlightening. It's been intriguing. John, how could someone - what's the best way to follow you, get in touch with you, and make sure that they're getting all the latest and greatest from Dr. Cochrane?
John Cochrane: Yes. So, I have a blog, The Grumpy Economist, that you mentioned. If you google my name, John Cochrane:, with an E on the end, you find my website, which has more publications for this audience. I just wrote a paper I'm very proud of called Portfolios for Long Term Investors, which has all words and no equations, a new first for me, and is trying to put together my summary of what my years of learning about asset prices has to say about how we do investing. You might find that useful. So, just google my name, and for the moment, I still come up first and I haven't been banned from the internet yet.
Casey Weade: Well, and that is a great article. We'll make sure to include all those links in the show notes. You can check it out at RetireWithPurpose.com. John, thank you for joining us on the show. Look forward to next time.
John Cochrane: Thank you.