If fiscal theory is right, even bigger federal deficits under President Trump could reignite inflation. It’s a good time to buy TIPS.
By William Baldwin, Senior Contributor
What drives inflation? Too much money, say the monetarists. When growth in the money supply exceeds growth in output, Milton Friedman declared, prices go up.
That’s not quite right, say some dissident economists gathering under the banner of “fiscal theory.” The bigger factor, they say, is deficit spending. More precisely: federal deficits unaccompanied by any prospect of an eventual paydown.
If the fiscal theorists are right, the future for holders of the usual kind of bonds, the ones without any inflation protection, is dark, even without any inflationary pressure that might come from increased tariffs. The Committee for a Responsible Federal Budget estimates President-elect Trump’s policies would add $7.8 trillion to the federal debt over a decade.
John H. Cochrane, a 67-year-old economist at Stanford University’s Hoover Institution, author of the 584-page Fiscal Theory of the Price Level (2023) and opinionated commentator on the blog “Grumpy Economist,” is probably the most vocal of fiscal theory’s proponents. It’s not merely the deficit number that determines inflation, he says. It’s how the market perceives the excess spending.
For two centuries the U.S. Treasury mostly borrowed like a responsible credit card user, running up debt to cover an exigency, like war or recession, and then paying it down, or at least seeing it decline in relation to GDP. That pattern has now broken down.
Although the financial crisis of 2008-09 looked like a one-off event and the bonds issued to combat it were readily swallowed by investors, the Covid episode was another matter, Cochrane says. The $5 trillion dished out to make up for lockdowns looked like a freebie that the populace was never going to pay back to the tax collector.
A central axiom of fiscal theory is that the market value of government debt is equal to the discounted value of future tax collections, minus future outlays for everything but debt service. This is the public finance version of a familiar stock market equation, which says that a company’s market value is the discounted present value of future profit distributions.
When the public becomes more skeptical of fiscal discipline in Washington, so goes the theory, dollars become less valuable and we get inflation. You can see the phenomenon in the graph of federal debt below. Unlike the lines customarily plotted, which recount the par value of the debt, this one shows its market value.
During the Covid splurge, expected future inflation went up, sending Treasury bonds to market discounts. For the first three years of the pandemic the bond crash was big enough to overwhelm the debt increases coming from new deficits. Fiscal theory interprets that decline in the market value of what the government owed as a mirror image of a decline in the value of expected future surpluses.
You see an increase in the price of eggs. Cochrane sees a decrease in the credibility of fiscal policy. That credibility will be hard but not impossible to win back. “A reputation for paying back your debt rather than defaulting or inflating it away is hard to gain and easy to lose,” he says.
What about the money supply, under the watchful guardianship of the Federal Reserve? Cochrane says the Fed does have considerable influence on inflation and interest rates, and thus on the discounting that goes into his formulas, but is much less powerful than people assume.
Consider the fuss made over “quantitative easing,” the process by which the Fed injects reserves into the banking system by buying up Treasury bonds. Supposedly that increases the money supply (narrowly defined as currency outstanding plus Fed reserves) and boosts the economy. But the fiscal theorists ask: Does this swap do anything? Is there really a difference between, on the one hand, hundred-dollar bills and reserves, and, on the other, tradable Treasury paper? All three, Cochrane says, are chits that have value because they can be used to cover future tax obligations. He sees all three as representing a discounted present claim on future surpluses.
TIPS Tips
Treasury Inflation Protected Securities pay a real rate, an interest coupon above and beyond the rise in the cost of living. Those rates, varying by maturity, now range between 1.8% and 2.2%. Such yields look meager but are a lot better than the subzero ones seen a few years ago.
Ideally, someone nearing retirement would have one bond coming due in each year between 2030 and 2059. That’s not practical, in part because trading costs are high on small purchases in the secondary market. But you could get close to the ideal by holding three large TIPS positions, due in 2030, 2040 and 2050, and then investing the proceeds of each maturing bond in a medium-term TIPS fund. The fund holdings, liquidated over the following 10 years, would combine to give you a 30-year payout. It’s a real deal.
In a digital economy, individuals can use these three kinds of money almost interchangeably. In lieu of money in your sock drawer or a balance in a low-yielding checking account, you can hold cash in the form of a fund holding short-term Treasury obligations. It takes only 24 hours to turn fund shares into classic cash.
Investors who hold long-term bonds rather than cash pray that the government will get its fiscal house in order. It could happen. Cochrane fantasizes that Congress replaces wasteful green energy subsidies with a carbon tax, working down the deficit from both sides. Not likely in the near future, but he says, hopefully, “Just like inflation, moments of bipartisan reform break out unexpectedly.”
Have bond prices hit bottom? A firm believer that a security’s price trajectory is a random process, Cochrane won’t make a market forecast. He can scarcely go against the efficient market hypothesis since his father-in-law is Eugene Fama, famous for propounding it. He says, “I would be kicked out of the family if I told you what a price should be that’s different from what it is.”
He does, though, have an investment recommendation. If you are in or near retirement, you should own TIPS (see “TIPS Tips,” above), locking in future spending power. You don’t eliminate the price volatility in the bond market but you can become indifferent to it. It’s a way to sleep at night while awaiting the day when budget writers start behaving themselves. The federal government ran surpluses between 1998 and 2001. It might do so again.
Further reading:
The Cochrane blog
In praise of gouging
A few modest proposals
Fiscal theory, at length
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