How John H. Cochrane Quit Worrying and Learned to Love the (Monetary) Bomb

A guest post by Benjamin Cole

For the past few years, conservative University of Chicago prof and blogger John H. Cochran has written skeptically about quantitative easing (QE). By his own statement, Cochrane even “collected” anti-QE missives for dissemination on his excellent blog, The Grumpy Economist.

So imagine the surprise when Cochrane recently sojourned to Stanford University’s Hoover Institution—a hardened redoubt of monetary asceticism—and professed his love for QE!

Not only that, Cochrane announced he was enamored of the Federal Reserve Board’s gigantic $4.3 trillion balance sheet—and, of course, the Fed booty hoard can’t be created or even maintained without a lot of QE.

Cochrane’s new swoon is no fleeting infatuation, he insisted. Indeed, he rhapsodized that the Fed’s Big Balance Sheet is a desirable permanent feature of monetary policy of the future.

“A huge [Fed] balance sheet, with [commercial bank] reserves that pay market interest, is a very desirable configuration of monetary affairs,” John Cochrane told fellow Hooverites, including the Monetary Rules King and host John Taylor, the famed Stanford economist.

Despite boldly declaring a new perspective, Cochrane became oblique on a few points, which he has not yet amplified, at least in writing or on his blog.

How Big a Fed Balance Sheet? 

Cochrane does not say if the Fed should add yet more to its QE-hoard of trillions in bonds. He provided no “Cochrane Rule,” such as “In normal times, the Fed balance sheet should be X percent of GDP.”

Indeed, Cochrane breezily asserts, “Fortunately the size of its balance sheet is also irrelevant. Interest-paying reserves are not inflationary. To the extent that the size of the balance sheet is correlated with stimulus or restraint, the sign is likely to change: raising interest rates via interest on reserves may come with an increase in the balance sheet.”

If you were in a bar, and translating that last sentence, you might say, “Cochrane says the Fed can fight inflation by buying Treasury bonds. By the trillions of dollars.”

Of course, that raises a question.

Can the Fed Pay Off the National Debt through QE?

This topic gets short shrift in Cochrane’s paper, and indeed in the entire economics profession. I think that is because it is embarrassing to admit that the hoariest and most evil red-letter cardinal macroeconomic sin of monetizing the national debt…is now thought a good idea.

It cannot be denied that the United States federal government has built up a mountain of debt starting with President Ronald Reagan (oddly exonerated by Cochrane, in a neat bit of intellectual gymnastics), running through the Bushes and reaching a zenith under President Obama. The national debt in relation to GDP is now back to post-WWII levels.

Cochrane points out that if interest rates rise, taxpayers are going to get whacked with hundreds of billions in added taxes, ceteris paribus. (Minor quibble: Cochrane assumes $18 trillion in federal IOUs, but in fact about $5 trillion of that is held in-house by federal agencies. The real debt outstanding is about $13 trillion.)

Yet, as jauntily expansive and prolific is Cochrane is on some topics, he becomes mute on the radical reduction or elimination of the national debt through QE.

But Cochrane did write that the national debt can be converted into the Fed balance sheet asset (QE) and consequent commercial bank reserves, and no worries—the Fed can pay interest on reserves by creating more reserves. By printing more money!

“Sure, the Fed can announce an interest rate on reserves, and can pay the interest by simply printing up new reserves when the time comes,” writes Cochrane.

Egads-o-Rama!

There was a lot more to Cochrane’s presentation to the Hooverites, entitled Monetary Policy With Interest on Reserves, and I hope some serious readers out there tackle the paper (online), and opine in this space (with permission of Marcus Nunes), or theirs.

We can wonder if parts of Cochrane’s Brave New World of Monetary Economics are strokes of genius or insanity. I am leaning towards genius.

After all, the Fed has monetized trillions in federal debt already (driving inflation-hysterics into overflowing freshwater-area insane asylums) and yet inflation has ground to a near halt.

Moreover, there have been two little-noted yet published Fed studies of late that concluded even massive amounts of QE would not be inflationary.

Yi Wen, assistant veep and economist with the St. Louis Federal Reserve Bank, issued a paper entitled, Evaluating Unconventional Monetary Policies—Why Aren’t They More EffectiveWen posited that a four-fold increase in QE would stimulate the national economy enough to close the output gap (!), and would be disinflationary. Something about portfolio investors switching to cash, wrote Wen.

A four-fold increase in QE, btw, would wipe out the national debt, if directed at US IOUs. Wen’s views echo an earlier paper published last year by the NY Fed.

And?

Well, there is a lot to ponder here. Here we have classic freshwater guys saying we can ramp up QE and wipe out the national debt, and throttle inflation.

You can have your cake, and eat it too, with a big dollop of ice cream, and keep trim along the way.

Why not give it a whirl?

4 thoughts on “How John H. Cochrane Quit Worrying and Learned to Love the (Monetary) Bomb

  1. Cochrane isn’t saying that the debt should be wiped out. He’s saying that he wants the Fed to monopolize maturity transformation (borrowing overnight to make term loans), in order to prevent bank runs. His concern is the stability of private banks.

    Notice that he talks about “reserves that pay market interest”. When people talk about debt monetization they implicitly assume a fixed 0% interest rate, regardless of market interest rates. That’s completely different (at least when market rates are >0%).

    • Max–

      Thanks for your comment.

      I mention explicitly that Cochrane wants reserves to pay interest, and that Cochrane says IOER would rise when the Fed fights inflation—but also the Fed balance sheet would rise, suggests Cochrane.

      I don’t see how you can dance around it. If the Fed buys enough Treasury IOUs, it starts to decrease the national debt (especially if the federal government runs balanced budgets). Basically, the national debt will be held by the Fed, and the Fed will pay interest on excess commercial bank reserves. But banks may start lending ut the reserves, decreasing that level of payment.

      Also remember—the Fed is also collecting interest on those Treasury IOUs! If the interest collected is higher than the interest paid out, then excess collections go back to the taxpayer.The debt is converted into a taxpayer asset into a taxpayer liability.

      There may also be times when the Fed sees a need to cut IOER (like now would be a good time). In those periods, again taxpayers would essentially be “off the hook” for debt repayment, and taxpayer IOUs would spin around and become taxpayer assets.

      I hope you agree this is a fascinating topic, and that an aggressive QE program makes a lot of sense. If we play it right, we can cut the national debt, fight inflation and boost the economy, and lessen the bite on taxpayers. Other than that, I like it!

  2. Thanks for pointing out the Cochrane paper. I will have to read it. But supposing it says what is illustrated here, with little reason to doubt, I think it would work only for some period of time before the supply side becomes a real mess, as helpful as it may be in solving the immediate problem of too many public obligations. Though I don’t see a way to monetize the obligations without having an ultimate result of disposing of the securities. And with that said, instead of burying it under a bunch of complexity they should just do it, perhaps as a one-time, get-out-of-debt-free card.

    • Dajeeps—I hope you can understand Cochrane’s paper, parts of which mystify me. I sense the Hooverites were not amused.

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