"If markets doubt that future taxes will cover today’s deficits, the price level adjusts until the real value of debt falls to match expected repayment."
Somehow I doubt that up until January 2021 markets were expecting future taxes to cover all the pre-2021 debt. But even is they did, price levels cannot rise without Fed validation.
You’re right that no one believes every dollar of U.S. debt will literally be retired by future tax surpluses. The fiscal theory doesn’t require that. What matters is whether investors see the present value of future primary surpluses as sufficient to cover the outstanding stock of debt. In other words, do bondholders expect that future taxes minus non-interest spending will, in present value, line up with today’s debt obligations?
Before 2020, the U.S. had at least some credibility on this score. After the financial crisis, deficits fell back to ~2–3% of GDP by 2014-2015 (1% for the primary deficit), and the debt ratio stabilized. Even with continuing deficits, investors could reasonably expect that growth plus moderate fiscal consolidation would keep debt dynamics in check (of course, my preference would be for a structural balance and occasional surpluses). A primary deficit of 1–3% of GDP could be eroded over time by 2% inflation and modest real growth, as indeed occurred during the 2010s.
The COVID era stimulus was different: primary deficits shot up to 10-13% of GDP in 2020–21. Crucially, unlike 2009–10, there was no signal of consolidation afterward. Instead, we layered on permanent new spending (ARPA, CHIPS, IRA, etc.) while already running large primary deficits. In that context, investors could doubt that the debt path would ever be stabilized by future surpluses.
So the issue isn’t whether markets believed all debt was “covered” before January 2021. It’s that the sudden jump in deficits, with no credible fiscal exit, shifted expectations about repayment capacity at the margin. That’s the channel Cochrane emphasizes.
It’s true that the Fed must validate inflation in the sense that it sets the short-term nominal anchor. But if fiscal backing is absent, the Fed faces an uncomfortable choice: either accommodate higher inflation or try to resist with rate hikes that themselves blow up debt service costs and risk more inflation down the line. The 2021–23 experience showed that even with rates below inflation, price pressures eventually subsided once the one-time fiscal shock had been digested. That’s hard to square with a purely monetary view.
Milton Friedman’s maxim: “inflation is always and everywhere a monetary phenomenon” is a powerful starting point. But Cochrane’s point (and the FTPL more generally) is that monetary phenomena don’t float free of fiscal backing. The quantity of money, or the policy interest rate, only pins down prices if government debt is credibly supported by expected surpluses. If fiscal policy undermines that backing, then monetary control is weakened.
So the disagreement isn’t whether money matters. It’s whether money alone suffices. Friedman assumed fiscal solvency in the background. Cochrane makes that assumption explicit and then shows what happens when it breaks.
Of course that depends entirely on the willingness of Congress to collect enough revenue and I doubt that bondholders don’t know that. Just a few more votes and the One Budget Busting Bill woud have failed and — poof — trillions of dollars less debt and higher growth.
But even if there were this sea change in belief about the debt, that still does not produce inflation without the Fed’s connivance. It just means higher interest rates and slower growth.
Yes, up to the point that the interest rate needed to hold inflation to target causes more damage than the inflation. But this is not to say that the deficits are harmless up to that point. Deficits in excess of productive public investment shifts resources from investment to consumption and that is bad however well the Fed may be managing inflation and employment.
"If markets doubt that future taxes will cover today’s deficits, the price level adjusts until the real value of debt falls to match expected repayment."
Somehow I doubt that up until January 2021 markets were expecting future taxes to cover all the pre-2021 debt. But even is they did, price levels cannot rise without Fed validation.
You’re right that no one believes every dollar of U.S. debt will literally be retired by future tax surpluses. The fiscal theory doesn’t require that. What matters is whether investors see the present value of future primary surpluses as sufficient to cover the outstanding stock of debt. In other words, do bondholders expect that future taxes minus non-interest spending will, in present value, line up with today’s debt obligations?
Before 2020, the U.S. had at least some credibility on this score. After the financial crisis, deficits fell back to ~2–3% of GDP by 2014-2015 (1% for the primary deficit), and the debt ratio stabilized. Even with continuing deficits, investors could reasonably expect that growth plus moderate fiscal consolidation would keep debt dynamics in check (of course, my preference would be for a structural balance and occasional surpluses). A primary deficit of 1–3% of GDP could be eroded over time by 2% inflation and modest real growth, as indeed occurred during the 2010s.
The COVID era stimulus was different: primary deficits shot up to 10-13% of GDP in 2020–21. Crucially, unlike 2009–10, there was no signal of consolidation afterward. Instead, we layered on permanent new spending (ARPA, CHIPS, IRA, etc.) while already running large primary deficits. In that context, investors could doubt that the debt path would ever be stabilized by future surpluses.
So the issue isn’t whether markets believed all debt was “covered” before January 2021. It’s that the sudden jump in deficits, with no credible fiscal exit, shifted expectations about repayment capacity at the margin. That’s the channel Cochrane emphasizes.
It’s true that the Fed must validate inflation in the sense that it sets the short-term nominal anchor. But if fiscal backing is absent, the Fed faces an uncomfortable choice: either accommodate higher inflation or try to resist with rate hikes that themselves blow up debt service costs and risk more inflation down the line. The 2021–23 experience showed that even with rates below inflation, price pressures eventually subsided once the one-time fiscal shock had been digested. That’s hard to square with a purely monetary view.
There is an excellent study by the Bank of England on the same dynamic in the UK: https://www.bankofengland.co.uk/-/media/boe/files/working-paper/2025/muddling-through-or-tunnelling-through-uk-monetary-and-fiscal-exceptionalism-and-the-great-inflation.pdf
I've also written about this in the context of fiscal dominance: https://www.theunseenandtheunsaid.com/p/inflation-risk-in-a-world-of-fiscal
Milton Friedman’s maxim: “inflation is always and everywhere a monetary phenomenon” is a powerful starting point. But Cochrane’s point (and the FTPL more generally) is that monetary phenomena don’t float free of fiscal backing. The quantity of money, or the policy interest rate, only pins down prices if government debt is credibly supported by expected surpluses. If fiscal policy undermines that backing, then monetary control is weakened.
So the disagreement isn’t whether money matters. It’s whether money alone suffices. Friedman assumed fiscal solvency in the background. Cochrane makes that assumption explicit and then shows what happens when it breaks.
The Fed’s mandate is maximum employment and stable prices, not being “comfortable.” :)
Of course that depends entirely on the willingness of Congress to collect enough revenue and I doubt that bondholders don’t know that. Just a few more votes and the One Budget Busting Bill woud have failed and — poof — trillions of dollars less debt and higher growth.
But even if there were this sea change in belief about the debt, that still does not produce inflation without the Fed’s connivance. It just means higher interest rates and slower growth.
"The great inflation we just lived through was a fiscal event, not a monetary one. "
Thanks for stating this error so clearly. Friedman has not been cancelled: inflation is every where and always a monetary event.
Here is a longer version of my dissent: https://thomaslhutcheson.substack.com/p/including-monetary-in-monetary-fiscal
Yes, up to the point that the interest rate needed to hold inflation to target causes more damage than the inflation. But this is not to say that the deficits are harmless up to that point. Deficits in excess of productive public investment shifts resources from investment to consumption and that is bad however well the Fed may be managing inflation and employment.
Where are all the MMT scholars these days?
Taking victory laps after passage of the One Budget Busting Bill.