Apparently when Paul Ryan went out for dinner and a $350 bottle of wine, his dining companions were some hedge fund jerk and University of Chicago economist John Cochrane. Not coincidentally, Cochrane published a paper relatively recently (PDF) that offers a novel model of fiscal and monetary policy in a recession that has the convenient property of affirming all of Rep Ryan’s political views. In particular, Cochrane argues that contra everyone on the Krugman-Bernanke axis, it’s simply not possible for either fiscal or monetary authorities to halt a deflationary trend. And he also argues that it’s not necessary to attempt to do so. And he warns that not only is it plausible to think that runaway inflation is right around the corner even though there’s no evidence of elevated inflation expectations, he argues that runaway inflation is likely to be sparked by tax increases and can best be combatted by gutting Social Security and Medicare.
Here’s a slice from the conclusion of his piece:
Will we get deﬂation? The ﬁscal analysis [i.e., Cochrane's mode] suggests that if discount rates for government debt fall, and demand for that debt rises, in additional “ﬂight to quality,” there may be very little that the Fed or even the government as a whole can do about it. However, the fear of a “deﬂationary spiral” comes from a view that deﬂation is caused by gaps, and gaps by real interest rates. The ﬁscal analysis denies this channel, so there is no fear of such a self-fulﬁlling “spiral.”
Will we get inﬂation? The scenario leading to inﬂation starts with poor growth, possibly reinforced by to larger government distortions, higher tax rates, and policy uncertainty. Lower growth is the single most important negative inﬂuence on the Federal budget. Then, the government may have to make good on its many credit guarantees. A wave of sovereign (Greece), semi-sovereign (California) and private (pension funds, mortgages) bailouts may pave the way. A failure to resolve entitlement programs that everyone sees lead to unsustainable deﬁcits will not help.
When investors see that path coming, they will quite suddenly try to sell government debt and dollar-denominated debt. We will see a rise in interest rates, reﬂecting expected inﬂation and a higher risk premium for U.S. government debt. The higher risk premium will exacerbate the inﬂationary decline in demand for U.S. debt. A substantial inﬂation will follow—and likely a “stagﬂation” not inﬂation associated with a boom. The interest rate rise and inﬂation can come long before the worst of the deﬁcits and any monetization materialize. As with all forward-looking economics, no obvious piece of news will trigger these events. Ofﬁcials may rail at “markets” and “speculators”. Economists and the Fed may scratch their heads at the sudden “loss of anchoring” or “Phillips curve shift”.
I obviously don’t have the technical chops to wrangle with Cochrane’s model in detail. I’ll note, however, that you might be a freshwater economist if you think it makes sense to reassure us that a deflationary spiral is impossible because your model says so even though deflationary spirals do, in fact, occur in human history. To me, a model that denies the possibility of something happening that does, in fact, happen indicates that you’re working with a flawed model. I also don’t understand what’s happened here to the traditional analysis of currency depreciation in a depressed open economy. If investors sell dollar-denominated debt, that means the global price of American-made real goods and services will decline. That means America’s output of real goods and services will go up. This might well be associated with a higher level of inflation by why “stag”? I also wonder to what extent was Cochrane trying to sell Ryan on his zero inflation idea.