Writing in the Wall Street Journal, John Cochrane argues recent events vindicate the fiscal theory of the price level (FTPL). According to Cochrane, and other proponents of FTPL, inflation is caused by a decrease in the present discounted value of budget surpluses. The federal government’s response to the economic challenges of covid exemplifies this view: “Our government borrowed about $5 trillion and wrote people checks,” Cohrane writes. “Crucially, and unlike in 2008, there was no mention of how the new debt would be repaid, no promise of debt reduction later.”

FTPL starts with the government’s consolidated balance sheet: the assets and liabilities of all its entities, including the Treasury and Federal Reserve. Massive spending increases without an accompanying commitment to tax increases put Uncle Sam permanently deeper in debt. But claims to American assets, including dollars (a zero interest-bearing liability of the Fed, and hence the government), are backed by future tax revenues. Hence, the value of the dollar must fall. People get rid of their dollars, exchanging them for everything else, which drives up prices. Voila, fiscal inflation.

FTPL essentially reverses the relationship between fiscal and monetary policy that I’ve asserted for a while. My argument is that deficits pressure the central bank to monetize, which creates inflation. But if the central bank didn’t monetize, there wouldn’t be inflation. Cochrane says this is backwards: the Fed helps the fiscal authorities implement helicopter drops, but is not the ultimate driver of dollar depreciation. In his own words:

The Fed is still important in fiscal theory. The Fed bought about $3 trillion of the new debt and converted it to interest-paying reserves. Giving people checks backed by reserves is arguably a more powerful inducement to spend than giving people Treasury bonds. Now, by raising interest rates, the Fed lowers current inflation but at the cost of more-persistent inflation. That smoothing is beneficial.

Cochrane also considers and dismisses alternate theories: supply-side inflation, the Phillips curve, “greedflation,”  and monetary policy-induced inflation. I agree the first three are wrong. But I’m not ready to give up on the fourth.

“Does money alone drive inflation?” Cochrane asks. “Suppose there had been no deficit, and the Fed had done another $5 trillion of quantitative easing, buying $5 trillion of bonds in exchange for $5 trillion in reserves.” In his version of the thought experiment, there would be no inflation, since this is merely a maturity swap; there’s no “net increase in wealth.”

This is where Cochrane stops his thought experiment. But he should have kept going. If he had, he might have realized something astounding: His analysis implies the Fed could buy every financial asset in the world without causing inflation!

Think about it: What if the Fed instead had done another $10 trillion in quantitative easing? $50 trillion? How about $610 trillion? Further suppose Uncle Sam’s fiscal position (deficits and interest-bearing debt) remained unchanged. Is it really thinkable that this would not cause hyperinflation? Yet FTPL says this should not happen. Cochrane is insistent that “overall government debt, including reserves, matters, not its particular maturity.” This conclusion beggars belief.

My problem with FTPL is that it specifies an end-state but abstracts too much from the path that leads there. In economics jargon, it’s an equilibrium condition without a mechanism. We need to know what the specific behavioral link is between permanent debt increases and permanent dollar depreciation. Old-school monetary theories have an easy answer: When Uncle Sam starts drowning in red ink, people rationally anticipate debt monetization by the Fed, and hence inflation. It’s not clear what FTPL’s answer is.