Why deficits are sustainable and inflation has a life of its own

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My new working paper “The Fiscal Theory of the Price Level in Overlapping Generations Models” is now available here. The paper, joint with Pawel Zabczyk of the IMF, is also available as CEPR Discussion Paper 13432 and as NBER Working Paper 23445. Here is a teaser from the abstract

“We demonstrate that the Fiscal Theory of the Price Level (FTPL) cannot be used to determine the price level uniquely in the overlapping generations (OLG) model. We provide two examples of OLG models, one with 3-period lives and one with 62-period lives. Both examples are calibrated to an income profile chosen to match the life-cycle earnings process in U.S. data estimated by Guvenen et al. (2015). In both examples, there exist multiple steady-state equilibria. Our findings challenge established views about what constitutes a good combination of fiscal and monetary policies. As long as the primary deficit or the primary surplus is not too large, the fiscal authority can conduct policies that are unresponsive to endogenous changes in the level of its outstanding debt. Monetary and fiscal policy can both be active at the same time.”

Given the recent publicity for deficit spending by Olivier Blanchard writing on his PIIE blog, or the interview with Stephanie Kelton in Barrons, we think our paper is timely. We demonstrate that sensible models with realistic population demographics support some, but not all, of the arguments of Blanchard and Kelton. For example, although a large value for government debt as a fraction of GDP is not necessarily a problem, large values of the deficit probably are. In our calibrated model, (in work in progress that is not reported in the paper) we were unable to generate sustainable deficits much larger than 3% of GDP. Anything larger than that leads to an Argentinian style hyperinflation.

It also matter, a lot, who holds the debt. Large values of domestically held debt are simply a redistribution from future to current taxpayers. Large values of foreign held debt however represent a claim on the domestic economy by foreigners. Foreign held debt is much less benign than domestic debt.

Finally, our work sheds light on the current difficulty faced by western central banks who appear to be unable to hit their inflation targets. Milton Friedman argued that inflation is caused by excessive money creation. More recently, some economists have argued that inflation is a fiscal phenomenon; hence the title of this post which refers to a new theory, the Fiscal Theory of the Price Level. In contrast to both leading contenders, we show that the price level may fail to be anchored by economic fundamentals and, within certain bounds, the average price of commodities may wander aimlessly driven by the self-fulfilling beliefs of market participants.

This is the second paper of a series. The first, “The Household Fallacy” was published last year in Economics Letters. Sty tuned for further installments.

Social Progress is not an Illusion

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I recently came across this critical review of Steven Pinker’s book, Enlightenment Now: The Case for Reason, Science, Humanism, and Progress, by Jeremy Lent in the online magazine, Open Democracy. Jeremy makes some good points, but then proceeds dramatically to overstate his case by painting a monothlithic concept of ‘free market economics’ as the enemy of progressives everywhere.

There is no such thing as free market economics. As I point out in Prosperity for All every market economy operates under a set of institutional constraints that determine the rules of the game. While Pinker may also have overstated his argument in places, it is hard to argue with the progress made by free trade and property rights in catapulting 1.5 billion Chinese out of poverty. The absolute income gains of Chinese peasants may not be as large as those of fortune 500 billionaires, but they are very real. And they were delivered by a move from central planning to a free market economy, and most importantly, by a recognition of the importance of property rights.

In his review, Jeremy downplays the gains of free markets. Instead, he brings us a vision of the ‘noble savage’ living by fishing and growing staples on a small patch of land which is then appropriated by mega corporations. Most of us would rather live as the median person in the wealth distribution in a modern industrial society than as a peasant farmer in a preindustrial utopia that has never existed outside of the minds of a few idealistic fellow travelers.

Capitalism does not deliver equality of outcomes. If our current institutional arrangements lead to a socially unacceptable degree of inequality, the right response is to change the institutional structure within which markets operate. It is not to give up on market exchange. And if there is a social consensus that the benefits of higher living standards are endangering the planet, the solution is to adapt market institutions not to destroy them.

In the twentieth century, inheritance taxes on large estates made a dent on the wealth distribution and to a seismic change in social relations. In the twenty-first century, Jeremy Lent rightly points out that social norms have evolved, and are evolving, rapidly. I for one, believe that some degree of inequality of outcomes is both inevitable and desirable as the cost of individual freedom. The ‘right’ degree of inequality is a question to be solved through open debate and institutional reform, not through a western replay of the Cultural Revolution.

Don't Trust the Markets

In a week when the Vix is at a seven-year high and the markets are back to the trading range of the summer of 2017, now seems like a good time to revisit the theme of market efficiency. Here is a link to the pre-publication version of an academic paper I published this year in the Review of Economic Dynamics.


The paper is a formal model of an argument I’ve been making for a while.  Although it’s not possible for the average punter to make a buck in the financial markets we should definitely NOT trust the financial markets to do a good job allocating capital intertemporally. As Richard Thaler explained in his review of Justin Fox’s book The Myth of the Rational Marketthe efficient markets hypothesis (EMH) has two components. 

The first, ‘no free lunch’ asserts that unless you have inside information, it is impossible to outperform the market except through dumb luck. That is almost certainly correct, although even that part of the EMH is disputed by some.

The second, ‘the price is right’, asserts that the financial markets allocate capital efficiently over time. Efficiently, here, means that there is no intervention by government that could make us all better off. That, despite the protestations of radical free-marketeers, is almost certainly wrong.  My paper explains why.

The financial markets facilitate trade with people not yet born. If you buy a stock and sell it twenty years later, there is a good chance the buyer wasn’t alive when you made the purchase. When you buy the stock for the long-run, you are betting that the buyer, twenty years from now, will pay more than you did. And the buyer is making the same forecast about the whims of some other buyer in the yet more distant future. This never-ending chain of market trades leads to the possibility that self-fulfilling prophecies lead to inefficient cycles of booms and crashes.

For the cognoscenti, here is the abstract from my paper

This paper constructs a general equilibrium model where asset price fluctuations are caused by random shocks to beliefs about the future price level that reallocate consumption across generations. In this model, asset prices are volatile, and price-earnings ratios are persistent, even though there is no fundamental uncertainty and financial markets are sequentially complete. I show that the model can explain a substantial risk premium while generating smooth time series for consumption. In my model, asset price fluctuations are Pareto inefficient and there is a role for treasury or central bank intervention to stabilize asset price volatility.

Have fun trading everyone and I wish you all a very  happy 2019. 

Conference at the Bank of England


Last year I co-organized a highly successful conference at the Bank of England on Economics and Psychology. You can find links to videos from most of the conference presenters here. This year I am co-organizing a second conference with the title, "Economics and Psychology: New Ways of Thinking about economic policy". The conference will take place on Monday July 9th and Tuesday July 10th. We have a tremendous line-up of papers with topics ranging from economic theory, economic and psychology experiments to behavioral economics and economic policy.

The conference will open with a keynote address from Seppo Honkapohja, former Deputy Governor of the Bank of Finland and closed by Vítor Constâncio, former Deputy Governor of the ECB. It promises to be an exciting event.  There is a limited number of spots for non-participants so, if you would like to attend, please send an email to Michelle Scott at the Bank of England. We welcome requests from academics, journalists and particularly from graduate students in economics and psychology. Space is limited so please don't wait too long to apply.

I am especially grateful to the Economics Department at the University of Warwick, the Bank of England, the Centre for Macroeconomics and the National Institute of Economics and Social Research for supporting both conferences. 

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Lend Me Your Ears: Friedman and The Role of Financial Policy

I was invited by Matías Vernengo, Co-Editor of the Review of Keynesian Economics, to write a paper, 'The Role of Financial Policy' in honour of the 50th anniversary of Friedman's Presidential Address to the American Economic Association. The Review will be publishing a special edition later this year and I am honoured to be writing in the distinguished company of many fine economists. 

Invited contributors that I am aware of include Brad DeLong, James Forder, Robert Gordon, David Laidler, Rober Pollin, Louis-Philippe Rochon, Sergio Rossi, Antonell Stirati, Servaas Storm and Nathan Perri.  


I opened my essay with a quote from Shakespeare's play, Julius Caesar.

Friends, Romans, countrymen, lend me your ears; I come to bury Caesar, not to praise him.
The evil that men do lives after them;
The good is oft interred with their bones;
So let it be with Caesar.


Opening an essay to honour the work of a great man by quoting from Marc Anthony’s words at Julius Caesar’s funeral, may appear to some to be a boorish opening gambit. But I do not mean disrespect. Milton Friedman was one of the greatest economists, if not the greatest economist, of the twentieth century. Friedman’s views of the appropriate role of monetary policy have become accepted wisdom and they form the core belief of every practicing central banker in the world today. That does not make them right. I come to bury some, but not all, of Friedman’s ideas. And as for Friedman himself, unlike Marc Anthony, I come to praise him.

My praise is for the influence of Friedman's ideas on the operation of monetary policy. Although his advocacy of a money supply rule was a failure in practice, his focus on rules evolved into the adoption of inflation targeting, implemented by interest rate control, that was a pillar of monetary policy in the last thirty years and was, arguably, responsible for the long period of economic stability that we refer to as the Great Moderation.

My critique of Friedman is of his insistence on the free market as a self-stabilizing system. The  Great Recession is just the latest example of the failure of that idea. Friedman was the greatest monetary economist of his generation. But the natural rate hypothesis, introduced in his 1968 Presidential Address, was a spectacular failure and we are only now digging out of the rubble of the New-Keynesian edifice that was constructed on this concept.

My solution, discussed in this essay, is to supplement inflation targeting with a new kind of financial policy that institutionalizes the role of the central bank as the lender of last resort.