The economic theories that become fashionable over the years are often those that meet the needs of the age. This is no different for John Cochrane’s fiscal theory of the price level, which has been gaining popularity recently as governments around the world grapple with the challenges of inflation and swelling debts. Cochrane’s theory posits that inflation is not simply caused by an increase in the money supply, but by a government’s liabilities exceeding its borrowing capacity.
In the fiscal theory, government debt is valued through asset-pricing models, with inflation occurring when future tax receipts cannot sustain the public debt. According to Cochrane, central banks alone cannot stop inflation; politicians must credibly commit to balancing the books. Furthermore, high interest rates are incapable of arresting inflation and are, in fact, inflationary.
Despite criticisms that Cochrane’s assumptions are far removed from our modern, financialized world, the theory may prove useful for the post-pandemic age. The fiscal theory highlights the need for monetary and fiscal coordination in controlling inflation, stressing that governments must do the heavy lifting. Cochrane also argues that there’s no need for central bankers to raise interest rates above the prevailing rate of inflation in order to get prices under control, which may be a relief for monetary policymakers given recent warnings of a potential global banking crisis.
While there are criticisms of the fiscal theory, it remains a useful tool for those seeking solutions to the challenges of inflation and debt. As governments continue to grapple with these issues, Cochrane’s fiscal theory could be a valuable resource for tackling the economic problems of our age.