A Different Story Of Inflation With John Cochrane

Episode Summary

In June 2022, Federal Reserve Chair Jerome Powell said, "we [now] understand better how little we understand about inflation." So what do we actually know about inflation? In this episode, Luigi and Bethany explore the origins of inflation with John Cochrane, Senior Fellow at Stanford’s Hoover Institution and author of the popular "Grumpy Economist" blog. They discuss Cochrane's new book, "The Fiscal Theory of the Price Level", where he offers a novel understanding of monetary policy by merging fiscal theory with the standard models of interest-setting central banks. Through a discussion of foundational economic principles such as Milton Friedman's theories – and the role of government debt, taxation, and spending levels – they shed light on what might drive inflation, and also on the requisite balance between democratically-elected institutions and independent central banks in the functioning of capitalism.

Episode Transcription

John H. Cochrane: The fiscal theory of the price level plus rational expectations—you need both of those ingredients—says that the inflation will largely go away on its own, without the Fed needing to raise interest rates to beyond 9 percent, so long as there aren’t more fiscal shocks.

Bethany: I’m Bethany McLean.

Phil Donahue: Did you ever have a moment of doubt about capitalism and whether greed’s a good idea?

Luigi: And I’m Luigi Zingales.

Bernie Sanders: We have socialism for the very rich, rugged individualism for the poor.

Bethany: And this is Capitalisn’t, a podcast about what is working in capitalism.

Milton Friedman: First of all, tell me, is there some society you know that doesn’t run on greed?

Luigi: And, most importantly, what isn’t.

Warren Buffett: We ought to do better by the people that get left behind. I don’t think we should kill the capitalist system in the process.

Luigi: In this podcast, Bethany and I discuss what is working in capitalism and what isn’t. One of the fundamental conditions for a capitalist economy to work is that relative prices convey information about the relative scarcity of goods. This information is what enables economic actors to actually invest resources where the demand for these resources is the highest.

Yet if prices move for reasons other than relative scarcity, capitalism doesn’t work very well. And so, one of the primary reasons, as we are all finding out today, why there is this noise is because you might have high levels of inflation.

In my view, even as an economist, I can say one of the surprising aspects of economics is how little we economists understand inflation. If you are a noneconomist, you think that there are some fundamental things that economists understand well, and number one is money, number two is inflation, and number three is unemployment. And we’re not doing that particularly well.

Bethany: I loved it when Federal Reserve Chairman Jay Powell said last spring, “We now understand better how little we understand about inflation.” Economists just don’t know that much about inflation, what generates it and how to fight it. I think a lot of us thought—at least on a very basic level—it was just about printing money. That’s what Milton Friedman once said.

And it sounds right, except if printing money automatically led to inflation, then in 2008, the Fed printed a lot of money, and we should have seen inflation over the ensuing decade. A lot of people predicted that we would, but we didn’t.

Japan has been printing money for two decades, and its inflation has never been above about 2 percent. So, if printing money isn’t the explanation for inflation, what is? Is there one, or do you agree with Powell’s quote?

Luigi: I do agree with Powell’s quote that we don’t know a lot about inflation. That’s the reason why it’s very important to go back to fundamental economic principles. There is no better person to do that with than John Cochrane.

Now, most people know John as a very opinionated writer of a famous blog, The Grumpy Economist. Most people ignore that John is also a very serious economist, and he has just finished writing a very serious academic book titled The Fiscal Theory of the Price Level.

He is really trying to change the explanation for why we see inflation. To do that, he tries to go to a very abstract world in which there are no frictions. So, imagine a world where there is no physical money but only bonds, so much so that even when people go grocery shopping, they pay with government bonds rather than with money. Then, of course, money demand, the obsession of Milton Friedman, and money velocity will make no sense, right? And so, all the stuff you learned in Micro 101 will be completely irrelevant in this world.

Bethany: In conventional economic theory, money and bonds are considered two separate things? In other words, money, money demand, money velocity—this is all cash money, whereas money that would be worth the same amount in the form of a bond is not considered money?

Luigi: Absolutely. So, what determines the real prices of bonds in this world? And so, be ready, buckle your seat belt, because we are traveling to the frontier of economic theory.

Let me start with a provocation. We know that Keynes loved to say that practical men are usually the slaves of some defunct economist. I think this is definitely true for monetary theory, where most people are in some way slaves of Milton Friedman and Milton Friedman’s mantra that inflation is always and everywhere a monetary phenomenon. You come out and say that Milton Friedman was wrong. Can you explain why?

John H. Cochrane: Well, a lot of what Milton Friedman said was right, but not everything. Time moves on, and even the giants can be improved on.

Now, it remains true—I think we’ve just seen some of this—if the government prints a lot of money and hands it out, people try to spend that money, and you’re going to get inflation. And that’s true equally in the monetary versus the fiscal theory of the price level.

The fundamental thing is, the Fed does not do that. We tell stories to our undergraduates, “What if the Fed prints money, drops it from helicopters?” You get inflation. The Fed is legally not allowed to do that, because that’s a transfer payment. Independent bureaucracies don’t get to give presents to voters, and they certainly don’t get to come and hoover up your money if they think there’s too much out there. That’s called taxes, and only politically accountable people do that.

Instead, what the Fed does is give you money but take back government bonds. If the Fed drops a bunch of money from helicopters, but at the same time the Fed’s burglars come to your safe and take the exact same number of government bonds, you are no richer or poorer than you were before. You simply have a portfolio that’s tilted slightly in a wrong direction.

In all good economic theories, you start with basic supply and demand, which isolates the most important thing, and then you add what we call frictions on top of that.

We start the fiscal theory with a very extreme version, in which money and government bonds are pretty much exactly the same thing. Why? Government bonds promise more money. That’s all they do. They say, here, we’ll give you more money in a year. So, how is that really different from money that you have right now?

The central question is, what’s the most important thing? You can start thinking about a world in which money demand is there but just doesn’t matter at all, because we’re awash in money. We hold our money as primarily a savings vehicle, not as something special just for transactions. You can start with a vision of the economy in which there’s no special distinction of money versus bonds. You can use bonds completely to make your transactions.

That’s the basic fiscal theory of the price level, whereas the monetary view takes that distinction between money and bonds and puts it at the base of everything and says, “Without that distinction between money and bonds, inflation is just uncontrolled.” So, the fiscal theory of the price level is perfectly consistent with money demand. It’s just not the central part of the story.

The central part of the story is, we should have defined it about 20 minutes ago. Where does inflation come from in the fiscal theory of the price level? The overall quantity of government debt, government-provided money and bonds. Relative to people’s expectations, will the government be able to pay off that debt?

Inflation comes when people say, “This is not going to end well. I’m sitting on some government money and some government bonds, and I’d better get rid of them now, before they all become worthless.” They try to spend them. Individually, you can get rid of them, somebody else buys them, but collectively, somebody’s got to hold them. And the only thing we can do if we collectively don’t really trust this government debt is to try to spend it and thereby drive up the price of everything else.

Let’s imagine a little village. We wake up in our little village, and people have government bonds in their pockets at nine in the morning. What happens? The first thing they do . . . The government bonds say, “You can have a dollar for each government bond.”

So, they get their dollars for their government bonds. They might use those dollars to make transactions, they might not. They might just sit on them. That doesn’t matter.

Towards the end of the day, what happens is, the government says, “Oh, you’ve got to pay taxes, and you’ve got to pay taxes in dollars.”

The amount that the government asks for in taxes is fixed in real terms. It’s 30 percent of your nominal income. If the price level goes up, the amount of money you’ve got to give the government goes up, and if the price level goes down, the amount of money you have to give the government goes down. If the price level is too low, at the end of the day, people have money sitting in their pockets more than they need to pay the taxes.

What are you going to do with it? Well, it’s four o’clock. You’ve got more money in your pocket than you need to pay taxes. You go out and try to spend it, and that drives up the price level. If it’s converse, if the price level’s too high, then you’re scrambling around to get enough money to pay those taxes by the end of the day. You’re not spending, and that drives the price level back down again.

Where do we end up? Well, the total amount of government debt in the morning, whether it was government debt or money, the price level is determined by that total amount of government debt relative to how much the government will soak up with taxes less spending at the end of the day. That’s the fiscal theory of the price level.

Now, it seems perfectly obvious. If the government says, “There’s going to be a big stimulus at the end of the day, and we’re just going to give you money, and we’re not going to soak it up with taxes,” you can see what’s going to happen. People are going to try to spend that money, up goes the price level. So, that’s perfectly obvious. I think it is perfectly obvious.

What’s surprising in there is what’s missing, and what’s missing in my story is any particular role for that money to facilitate transactions. You could use bitcoin, you can use credit cards—it doesn’t matter in that story. All that matters is the total quantity of government debt relative to how much will get soaked up in taxes.

Bethany: How does the prevalence of crises in our modern financial world and the way in which a crisis changes the perception of this interchangeability of certain instruments and cash affect the theory?

What I mean by that is, if the question isn’t clear, as you think back to the global financial crisis of 2008, up until everyone all at once started to lose confidence in mortgage bonds, everybody trusted subprime mortgage bonds as a form of collateral. All of a sudden, they didn’t anymore.

Or you think, maybe perhaps more clearly, to the onset of the pandemic, in the spring of 2020, when all of a sudden, Treasuries and cash were not at all interchangeable, and everybody began to sell Treasuries all at once, due to the perception that they just wanted cash. How does a crisis affect this? And because these crises seem to come so regularly, does this matter?

John H. Cochrane: Not as much as you might think. A lot of the crisis is purely a financial affair that really doesn’t have that much to do with inflation. In fact, in our financial crisis, inflation went down a little bit after the recession, but it really wasn’t an inflationary price-level phenomenon.

Now, where it may become central soon is sovereign debt. Sovereign debt, which has no collateral, has always been very risky. And our era is very strange in thinking of sovereign debt as the most safe of all things. Where fiscal theory will interact with financial stability is the possibility of . . . We’ve seen it in emerging-market countries. When an emerging-market government gets into trouble, there is a sovereign-debt crisis, there is inflation, there is devaluation. Those mechanisms are perfectly well understood, but Americans and to some extent Europeans have this, “Oh, well, this will never happen here” view about that stuff, but we also thought inflation would never come back again.

“Don’t bother writing that book, John,” I have been told. “We’ll never see inflation again in our lifetimes.” Well, there is some amount of debt deficits and no plan whatsoever of paying it back when that sovereign-debt crisis comes to the US, and that means a big inflation in the advanced countries. This is where I would link the crisis mechanism and inflation.

And just to go on a little bit more. Our governments have exposed themselves to a crisis in the same way that banks in 2008 exposed themselves to a crisis. We have deficits that are going to last until Luigi’s and my great-grandchildren are around. We have no plans for playing it back in their lifetime.

If you have a corporate structure like that, you might want to borrow long-term debt to lock in the financing. Any household, if you lock in the 30-year mortgage and interest rates go up, you don’t care. You just pay the interest payments. Our governments have these deficits lasting decades, but instead, they’ve taken the adjustable-rate mortgage. They roll over short-term debt. Well, financial crises are always and everywhere problems of short-term debt. And our governments are largely rolling over short-term debt rather than locking in those long-term rates, exposing themselves to the risks of such a financial crisis, so that’s another area where financial crisis and inflation relate.

Luigi: Maybe I’m wrong here, so that’s why I ask this question. I would have answered Bethany’s question very differently, because I would have said that you really touch upon the difference between my theory and the conventional wisdom.

The conventional wisdom is all about demand for liquidity, demand for money. When there is a financial crisis, people panic and enormously increase the demand for money. The government can satisfy this demand as much as it wants, because if there is one thing the government can do very well, it is print money. So, people all of a sudden panic, and they want to hold the green piece of paper, the government prints it, and as a result, you have an enormous increase in money but no impact on inflation. Why? Because if you believe in the fiscal theory of the price level, the total liability of the government has not changed.

All of a sudden, one morning people wake up and say, “I really want money and not bonds.” And if the government is stupid enough and says, “No, I’m not going to give you money,” then we have the 1929 crisis. But if the governments might not say, “OK, you want money? Sure, I’ll print as much as you want, and I’ll take back some debt, and as long as I keep the future deficit constant, nothing happens.”

A lot of people raised . . . In their quantitative theory of money, when they saw the 2008 financial crisis, and they saw the balance sheet of the Fed ballooning to $3 trillion, they said, “Inflation, inflation, inflation,” and inflation did not come.

John H. Cochrane: Thank you, Luigi. You want to go on the road with me? You brought up something that I do want to pound my fist on the table about a little bit, because I regard it as a major success.

In the financial crisis and its aftermath especially, the era of the zero bound, we had an experiment like we have never seen in monetary theory, and predictions were made ex ante that were exactly correct according to their theories. The monetarists actually weren’t that big on deflation happening, because the Fed did supply liquidity like crazy in the financial crisis.

Ben Bernanke said, “Milton Friedman, we’re not going to repeat the mistakes of 1933,” and they didn’t. Then the zero-bound era hit. And when interest rates hit zero, classic Keynesian theory makes a clear prediction that you will have a deflation spiral. The interest rate is too high, you start to get a little deflation, which we did get a little bit of deflation.

Now, the real interest rate is too high, that lowers aggregate demand, deflation gets worse, it spirals away uncontrollably. And they very clearly said, and for years afterwards, anytime you’re at the zero bound, a deflation spiral could break out at any time, and it never happened.

So, there was a clear prediction and clearly false. And fiscal theory says, no, there is not going to be a big deflation. And there’s a very clear reason why there won’t be deflation. Because if a 30 percent deflation broke out like in the Great Depression, that raises the value of government debt by 30 percentage points. And the government has to either raise taxes and cut spending by 30 percent, enough to pay that 30-point rise in the value of government debt, or default. But otherwise, you can’t have that deflation, because the debt isn’t worth that much.

Well, our government, in the depths of a recession, a financial crisis, a deflation, they’re not going to raise taxes and cut spending to pay a windfall to Wall Street fat cats who own bonds, an unexpected and totally undeserved windfall. That’s not happening.

A fiscal theorist looks at that and says, “Nope, there won’t be deflation.” Score one. Score two, where the monetarists got it wrong, is then we did quantitative easing. Quantitative easing is where the Fed does this classic exercise of take in Treasury debt and give you money in return. And we did it on an atom-bomb scale. The Fed’s quantitative easing was trillions of dollars, thousands of times bigger than any purchase of Treasuries and giving of money ever was in the past. The monetarists were exactly right given their view of the world. They said, “Here comes hyperinflation, you got to be kidding.” You raise reserves by 3,000 percent.

So, where are we on QE? We’re arguing about whether it lowered long-term interest rates by a couple basis points or not. You set off what was supposed to be an atom bomb. There’s arguing about whether there was a firecracker, then, boom, zero.

Whereas, of course, the fiscal-theory view that overnight reserves and short-term Treasuries are basically the same thing would also say, “Who cares?” Not much. We had a classic experiment, and since you brought up the era, I just wanted to try to do a little bit better on selling my book that it just passed one of the most decisive experiments you can ask for in monetary economics.

Bethany: What does this mean for Federal Reserve policy right now? When you look at what the Fed is doing, how the Fed’s current actions intersect or don’t intersect with your theory, is there anything you would like to see the Fed doing differently, as a result of how you’re thinking about inflation?

John H. Cochrane: Inflation is now running about 8 to 9 percent, and the Fed has raised interest rates to about 2 percent, and even the hawks are talking, get up to 5 percent or more. Yet standard traditional economic theory, the standard lesson where Luigi and I were taught in grad school about the 1970s, is that until interest rates get higher than inflation, inflation will continue to explode upwards. So, is the Fed, by moving so slowly, pouring gas on this fire, or is the Fed actually doing some good here?

If you look at the standard New Keynesian models that say, “The Fed can raise interest rates and lower inflation,” you look into the footnotes and they say, “Oh, by the way, when the Fed raises interest rates, Congress passes big tax increases and spending cuts.” Not happening. So, we have to ask ourselves, can the Fed raise interest rates? And without that footnote kicking in and fiscal policy getting off the gas pedal, that won’t do any good.

Now, that traditional view failed, it predicted a deflation spiral. There was no deflation spiral, so maybe we might get out of this one if there aren’t any more fiscal shocks and this one-time fiscal shock could go away. The fiscal theory of the price level plus rational expectations—you need both of those ingredients—says that the inflation will largely go away on its own without the Fed needing to raise interest rates to beyond 9 percent, so long as there aren’t more fiscal shocks.

Now, giving away a trillion bucks in student-loan debt relief, that’s another trillion-buck fiscal shock. And in Europe we’re about to see what they do in the long, cold winter ahead as far as . . . The UK is already handing out 100 billion pounds to pay everyone’s electric bills.

So, we may see more fiscal shocks. That doesn’t count in this prediction. But if I were in a policy position, the equations out of John’s last book aren’t necessarily what you want to bet your life on. That’s an example of one where, as a profession, as the art of central banking, we have some history. We have some examples. We have theories on both sides, a genuine lack of knowledge. I’m willing to say, I think it might go away, but I’m also not quite so sure. And, boy, that one matters, doesn’t it?

And as a final note on this one, you compare . . . What I’ve just described as a genuine debate about, is inflation stable? If you don’t do much to interest rates, does inflation fade away of there are no new shocks, or does inflation spiral away? We’re not really sure about that.

Now, compare the level of self-proclaimed technocratic expertise in fine-tuning all the gears and frictions and constraints and so forth that comes out of the ECB and the Federal Reserve. It’s almost laughable how much they pretend to understand a Rube Goldberg machine when such basic questions like this are still a little up for grabs.

Luigi: John, do you have an extra five or 10 minutes?

John H. Cochrane: I can go all afternoon, Luigi, I’m having a great time. We just need a glass of wine and . . .

Luigi: That’s next. I love the answer you gave Bethany, but I have a slightly different view. And one thing I love about the fiscal theory of the price level is what you said, that it brings a footnote to the center stage. Economics has this defect of trying to put everything that is difficult and political as mere consequences of some technocratic decision. And when they can’t really hide it, they hide in a footnote. They do a disservice to everybody.

And what John’s book makes very clear is that inflation is always and everywhere a political phenomenon, because it is about how much you want to tax people now and in the future. A lot of the game that the Fed plays is a game trying to push the fiscal authority to do X or Y. Because at the end of the day, what pins down in the long term the level of prices, and so the inflation, is the fiscal policy. And the monetary policy is only when you’re going to get the pain, and to some extent, are you going to get the pain? But the pain is going to come one way or another.

The independence of political monetary authorities is sort of a game that they play, trying to have the monetary authority take their responsibility to push the fiscal authority to do something, and then the fiscal authority says, “Oh, we have to do it because the bond market is saying that or because X is doing that or because the euro is saying that.” But the reality is, you have to pay for what you borrow sooner or later, and so, this is ultimately a fiscal decision, and the political authority is trying to hide their responsibility by giving it to somebody else.

John H. Cochrane: I think Luigi’s right, but I want to put the same observations . . . Luigi has a very cynical, Italian spin on politics. I want to put an American spin on the same thing. It’s a political thing, but even a well-run political system involves constitutional limits. We have created Federal Reserve independence along with a lot of legal limits on inflationary finance. And that structure . . . I admire American constitutionalism as a way of thinking about politics. We agree ahead of time on some rules of the game that create institutions that make it harder to inflate ex post.

Luigi: OK, we don’t want to take too much of your time, but this was fantastic, John. Thank you very much.

John H. Cochrane: Luigi and Bethany, thank you so much. Your questions were great. I’m sorry your questions were so good that my answers were long, but we also have to make it clear, and wish me luck.

Luigi: Bethany, did John enlighten you?

Bethany: I find it really fascinating that bonds and money have been thought of as two separate things in models of inflation or models of the economy. From a noneconomist’s standpoint, that was a really interesting insight.

And it does seem, given the point that you made earlier, that we are moving further and further away from cash, that if models are based upon cash money, then we really need to be rethinking that. That, in and of itself, is really interesting to me.

It does seem, though, that the inputs of his model are not only unknowable, but that the inputs all depend upon each other. In other words, this is not just algebra, it is multivariable calculus. And it’s not clear to me that there’s a solution or a way to know these things. That said, I think frameworks can be really valuable, so it feels like an elegant framework rather than something that’s going to spit out a number and tell us what inflation is and what it’s going to be.

What did you think? Did our discussion change your view in any way?

Luigi: First of all, credit to John . . . It is not the first or the last model with this characteristic. If you go back to Milton Friedman, the quantity of money or the way he applies the quantity of money is a very clever rhetorical device, because he starts from an identity that defines velocity and then assumes that velocity is constant. And with that assumption, he gets a theory that links the quantity of money to the price level, assuming that there is no effect on income. And that is all that we have of the theory of inflation in Friedman.

In this respect, John is no worse. However, it is tricky to apply this in practice. I think that this is the danger which has always existed, but I think these days it is particularly intense, because the distance between the creation of economic theory and the publicity in the larger world is negative. Things get diffused even before they get finished. So, I think that there is not time to absorb them and transform them in a way that makes them more realistic and makes people understand where the bodies are buried.

With this said, I think that what I love about this model is the fact that it makes it very, very explicit. Something that is hidden in all the literature on inflation, monetary authority independence, and so on and so forth.

He makes explicit that at the end of the day, there is a budget constraint and that much of the action of the Fed, the reason why it works, is because, directly or indirectly, it makes a difference for this budget constraint. But that’s something that people don’t want to talk about.

Let me give an example. When you increase interest rates, it’s true that you might decrease investments or demand, but at the same time, you are also pressuring the government to basically reduce their real expenditures. Because for a given level of debt, if interest rates are higher, it means that the government needs to pay more in interest, and it either increases the deficit, or the government needs to increase taxes or spend less.

At the end of the day, most of the time, you see that the government’s going to spend less, at least less than what would be the alternative if interest rates were lower.

And so, indirectly, the monetary authority is making an impact on the fiscal authority. This is called monetary dominance, because it is the monetary authority giving direction to the fiscal authority. And there are other cases of fiscal dominance, in which the government is so reckless in running deficits that the monetary authority can do nothing but print money to basically avoid a government shutdown. These are the two extremes.

What I think is not well recognized, at least in the public at large, but often even in academic debates, is the fact that many of the institutions that we design—central bank independence, for example—is a way to give more power to the Fed to reduce the deficit of the government.

Bethany: I want to come back to that, but before we move to this really important question, I did want to pause on one thing that does not make sense to me about John’s model. If bonds and money are equivalent, then quantitative easing is nothing. If quantitative easing is a nothing-burger, why did the Fed start doing it in the financial crisis, and why did the Fed continue to do it throughout the previous decade in such huge quantities?

And I’d just add to that this notion that market participants don’t think QE is a nothing-burger. They view it as a sign that the Fed is trying to keep interest rates low. Therefore, it’s a bullish signal. Therefore, it leads to an increase in asset prices, which, in and of itself, then has an impact on the real economy.

You may disagree with some of that. This may be a place where academics and market participants wildly disagree about the effects of Fed policy. But that seems to me . . . This idea that QE is a nothing-burger versus this idea that it’s a very pivotal tool in the Fed’s toolbox seems to me to point out a little bit of disagreement with John’s model.

Luigi: I don’t think so. John is very clear to say, “Look, this is a model without frictions.” When we started describing the model, I said, “Imagine that you go and buy groceries at a store with bonds.” Now, you don’t, right? You buy groceries with cash or a credit card. Now, the credit card may be backed by bonds, but anyway, you see that there are important frictions.

In everyday life, these frictions are important, and financial players especially, financial investors, make a lot of money playing on these frictions. For them, it is a game changer, but it is not really a dramatic change in substance. And, in fact, quantitative easing per se has not changed inflation at all. The experience of 2008 is very clear.

Now, you added another hypothesis in your statement, which needs to be evaluated very carefully, that quantitative easing carries importance for expectations. Now expectations are the name of the game. Expectations can have a huge impact—an impact that we don’t understand particularly well, but an impact that is very, very important. We know that it’s very important. So, in the limit, if we know deficits change with the solar eclipses, solar eclipses become very important, not because they directly affect the economy, but just because they affect the way we think about them.

Bethany: That makes sense to me mostly, except if you were to read the popular press, you would for sure believe that the Fed’s massive quantitative easing, with respect specifically to mortgage bonds, played a huge role in driving mortgage rates to the super low levels that they were at before inflation started to set in. Do you disagree with that? Do you think that the Fed’s massive purchases of mortgage bonds had no real impact on mortgage rates? And, again, if so, I’d ask, why did they do it?

Luigi: I think the evidence I’ve seen is, there is a little bit of an impact, especially on the longer-term rate and particularly on the first QE. But otherwise, there is even a debate about whether QE had a large impact.

I think that I like what Matt Stoller told us about—what do you call it? The Cantillon effect. Basically, QE has enriched the financial sector, because if you print money, the closest place to the printing press benefits tremendously. In that sense, I think that QE was very important, but in really pushing the economy or pushing inflation, I don’t think that it was overwhelmingly important.

Bethany: But then, I’ll come back to my question. Why did the Fed do it and in such massive quantities? I mean, the Fed may have wanted, on some sort of subconscious level, to enrich financial-market players, but they certainly didn’t explicitly want to make hedge-fund billionaires. So, again, why do this, and why do this to the scale that the Fed did, unless they believed it was having more of a real impact?

Luigi: Well, I think that the reality is they were running out of instruments. So, if the interest rate is zero, how can you try to stimulate the economy? You want to stimulate the economy by saying, “I am going to keep interest rates low for the long-term future, and eventually, I’m going to create some inflation.” That’s what QE was: a promise. And I think that, to some extent, they delivered on that promise, because when you saw the economy coming back up, they should have stopped and inverted and started to raise interest rates right away. They didn’t, and so, in that sense, it was successful.

Bethany: Maybe a way to sum this up is that this has been a learning experience for the Fed, too. I mean, after all, QE was a new policy. So, the pros and cons and real versus imagined effects of QE are still something that the Fed itself is figuring out.

We could change the start of this episode. Instead of quoting Powell saying we don’t really understand inflation, we could put a different quote in place and say, we don’t really understand quantitative easing.

Luigi: Absolutely.

Bethany: But then, the question is this: I thought in listening to you and John talk, and based on what you just said, that you are both very much in favor of having a very independent central bank, of having the monetary authorities have a lot of independence, and that perhaps you trust them more than you do the fiscal authorities. In other words, you’d rather have monetary dominance than fiscal dominance. Is that a fair interpretation of either of your points of view or not?

Luigi: I don’t want to speak for John, so let me speak for myself. I think I review my views over time, and there is no doubt that there is a risk of runaway inflation with governments that are not particularly fiscally prudent. It’s also true that in developed countries, where you have a good understanding of the situation, this is relatively unlikely.

I’ve developed a resentment for, basically, a technocratic attempt to put limits on the ability of people to shape their destiny. This is very much influenced by my experience of Italy joining the euro. The euro was designed, for Italy at least, as an orthopedic structure to force Italy to behave in a certain way. But it wasn’t really sold as an orthopedic structure. So, it was said, “Oh, this is good for you, but I won’t explain exactly why it is good for you.”

If that’s what it’s doing, it should be approved, for example, with a much larger majority of constitutional change, because this stuff is very hard to revert, and there are a lot of consequences, so it’s not something that can be sneaked into a law at night. It should be done with a lot of debate on the costs and benefits.

Bethany: It does seem, in many ways, that the Federal Reserve, that the existence of a monetary authority that is independent from politics, is in some ways designed to restrict the ability of popular will to affect policy. Is that a good thing, or is that a bad thing? Is that a necessary condition for capitalism to work, or is it dangerous?

Luigi: This is where I think there is a wide disagreement about to what extent you trust universal suffrage. And if you think that people are a mob that needs to be educated and restricted, then of course you like to put on corsets, blinders, and all those things to get them to go in the right direction.

If you think that democracy is not just having a regular exchange in government every so often, but a way to convey the needs and the desires of people into public policy, you don’t want to have too many corsets. I believe that we can have a capitalist system with fewer corsets if there is a popular buy-in for capitalism. If there is not a popular buy-in because capitalism does not deliver for everyone, then you start with a corset and you end with a tax. It is very hard to know where you stop, right?

Bethany: Right. It’s interesting, because that tension is explicitly in the founding of the United States. The founders tried to design a government that would resist mob rule, and then there are these institutions that have been put in place over time that are supposed to—maybe—aid our ability to resist mob rule. But, of course, democracy in its purest form should be mob rule. So, I think that that fundamental tension goes to the very heart of any democracy. Do you agree with that?

Luigi: Yeah. And I think, let’s not forget that the Constitution was written 250 years ago, when the world was very different. First of all, the level of widespread education was very different, and I think the ability to self-determinate was very different. Maybe 250 years ago, this was not a crazy idea, but I think today it is pretty anachronistic.

Bethany: Yep. It’s maybe worth remembering when we place so much weight today in the hands of central banks around the world, or we place so much power, rather, in the hands of central banks around the world.

Luigi: I completely agree.