Cochrane has posted his ‘hard debt’ WSJ op ed on his blog.
The op-ed deals with three related questions:
1/ What might monetary policy mean for fiscal policy?
2/ Does this matter more or less in a time of large deficits?
3/ What might be done to mitigate the risk of conflict?
These are key questions, which were well understood some time ago — but which became relatively uninteresting in the great moderation as deficits shrunk and monetary policy became fully independent.
The link between fiscal and monetary policy is fairly intuitive. Imagine that there is only one interest rate (the overnight rate) and that the government finances all their debt at that rate. Well a rate hike increases government costs (debt service) and may shrink revenue (by lowering consumption and investment). If we impose a long run balanced budget constraint (but allow a stock of debt) a channel through which higher rates works to constrain total demand is via lower government spending (and maybe higher taxation which if nothing else imposes some deadweight losses).
So, when the central bank raises rates, they are demanding some sort of fiscal adjustment from both the public and private sectors. It is normally very small, so we ignore it in most models, but it is there. Cochrane makes the reasonable argument that larger sums of money are a bigger deal (note, 900bn is 5% of 18bn, so Cochrane is using the single-rate simplification, saying that rates go from 0% to 5%)
Monetary policy depends on fiscal policy in an era of large debts and deficits. Suppose that the Fed raises interest rates to 5% over the next few years. This is a reversion to normal, not a big tightening. Yet with $18 trillion of debt outstanding, the federal government will have to pay $900 billion more in annual interest.
So what would a captured monetary authority do if the fiscal authority didn’t like its actions? It might lower rates, or perhaps monetize fiscal deficits — allowing the fiscal authority to shift the adjustment onto the private sector via an inflation tax.
Clearly, the US debt, large as it is, is not all overnight. Part of it is long term – so the immediate hit even if the Fed tightens to 5% will not be 900bn (however larger deficits and slower growth may be resisted in any case).
This is the nub of Cochrane’s argument, really — that to better preserve the independence of the monetary authority, the fiscal authority should term out their debt so that rate changes do not hurt them so much. If you are at 30yrs, it is a long time before it matters (way after those mid-terms!).
Of course, as the Fed is the taxpayer, this also means the Fed should not be buying USTs.
I am not so sure this is the best outcome — i would allow QE but insist on an accord that the Treasury recapitalize the Fed in the case that they take a loss on their UST portfolio.