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The insights I’m going to be talking about today are derived from rather complicated dynamic models –

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which I’m not going to be able to explain to you in detail, so you’ll understand them in half an hour.

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My aim is to give you some basic intuition about the new types of theory about inflation and public debt

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that I think are becoming more and more central to macroeconomics - and some of their nonstandard conclusions.

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And hope thereby to motivate you to actually understand the theory by going and reading the literature.

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The way many people have been taught to think about inflation is the monetarist view

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that velocity, the ratio of nominal income to the stock of money, whatever that is, is a fairly stable quantity.

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M, the money stock, is under the control of policy.

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And this implies a simple one-dimensional, one-directional causal model, connecting policy to inflation.

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Money growth determines the growth of nominal output: P times Y.

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And since it can have no long-run effect on output, it alone determines inflation in the long run.

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If you read Milton Friedman’s more popular articles,

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this is the view that you will see coming through every time he talks about inflation.

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But this theory no longer works for several reasons.

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One is that in the simple monetarist models, when they’re made formal, M is non-interest-bearing government-issued currency.

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Of course, most of the money stock, as it’s usually defined, is not currency;

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it's various kinds of deposits that are labelled as transactions deposits.

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So M1 includes bank created money.

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And in a simple monetarist theory, what you learned in first year economics text books before 2009,

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was that there was a money multiplier and that was high-powered money,

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which was non-interest bearing reserves plus currency that was controlled by the government.

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And there was a money multiplier that reliably translated high-powered money into M1.

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But in rich economies today nearly all deposits in principle pay interest.

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Though right now the interest is trivially small in many cases.

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Even chequing accounts and reserve deposits at Central Banks pay interest.

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Reserve deposits at Central Banks, in other words, are now yet another kind of interest-bearing public debt.

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They are not distinguished from public debt that bears interest by the fact that they don’t pay interest.

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The only thing left that’s non-interest-bearing government paper is currency.

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And currency is not M.

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Most of the statistical work on monetarist views of inflation is very explicit that M is made up of more than just currency.

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So I’ve said one reason the theory doesn’t work is that now everything pays interest.

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But of course right now nothing pays interest, or rather all short-term securities are paying almost nothing.

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Central Bank reserve deposits now pay interest but it’s very low.

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In the US short-term government debt, treasury bills, pay lower interest than reserve deposits at the Central Bank.

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And this has led to banks' willingness to hold reserve deposits far in excess of required reserve ratios

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which has made the money multiplier completely obsolete.

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It’s no longer true that there is something you could call high-powered money.

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And that there’s a strong tendency of the money stock is usually measured to grow in proportion to the high-powered money.

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And as I’ve said reserves in the US and almost all Central Banks now pay interest.

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They’re just another form of government debt, not that much different from treasury bills.

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So the notion that there is something called M that’s used for transactions and doesn’t pay interest,

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and is distinct from interest-bearing public debt - that’s essentially obsolete.

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So how do we think about determination of the price level?

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The theory that I’m going to talk about is more complicated than MV = PY.

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And so I’m not going to be able to convince you in the way you should insist that you be convinced

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if you’re economics graduate students or young economists in general.

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But I’ll just give you a brief idea of the intuition behind it.

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In replacing MV = PY is this equation, B over P, where B is nominal government debt.

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This is fiat debt, debt that’s government paper.

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It promises to pay more to government paper at maturity.

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P is the price level so B is the market value of outstanding public debt.

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So if there’s long-term debt, its market value may fluctuate even in nominal terms.

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So if debt is issued at 5% 15 years ago and is still on the market at a time when the market short rates

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have dropped down to 1% or less, that debt is going to have a much higher market value in nominal terms.

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But then we divide by the price level to get a real value of marketable government debt.

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And the equation is that that should turn out to be equal to the discounted present value of primary surpluses.

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Primary surpluses are revenues less expenditures.

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Now, the expenditures do not include interest payments on the debt when you’re calculating the primary surplus.

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And in conventional budget accounting for, when you look at the government deficit as usually computed,

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interest expense is counted.

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The primary surplus subtracts interest expense.

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This is a simplification for many reasons.

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The most important one in this version of the formula is that it assumes

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that there is a constant known real rate of interest, rho.

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Of course, the real rate of interest does vary over time.

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But as a simplified view, assuming a constant real rate of interest

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is much like assuming a stable velocity in the monetarist theory.

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So this is a simplified view of this other way of thinking about determination of the price level.

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And I don’t have to explain how to drive it in detail.

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When I present this theory to audiences that include mostly people from the financial industry,

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they find no difficulty at all in understanding this formula.

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It’s derived the same way the usual valuation equations for bonds or stocks are derived.

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In fact, sometimes I’ve had experienced people from the financial industry

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who said that seeing this kind of theory of the price level finally makes sense of determination of the price level to them.

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And they’ve never been able to understand MV = PY.

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But if you’ve had too much economics this may seem like a very strange and bizarre theory.

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And so I’ll ask you just to accept it for the time being.

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If you want to understand what kind of model produces it, there is a bunch of papers and literature that produce it.

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There’s lots of controversy about exactly what the implications of this model are.

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If you come to the discussion section this afternoon, I’ll try to give you references to papers where you can pursue the theory.

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But it is clear that this is less simple than MV = PY.

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For one thing an equation like MV = PY will still be part of any general equilibrium macro model.

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It doesn’t get replaced by this bond valuation equation.

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It coexists with it in equilibrium.

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Furthermore, it doesn’t simply replace the M causes PY uni-directional model, one-dimensional model,

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with a nominal debt causes PY uni-directional model.

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This is one widespread misunderstanding of this theory which is called the fiscal theory of the price level.

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People often think, well, the fiscal theory of the price level must be just like monetarism

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except with nominal debt instead of money.

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So when there are big deficits it must predict there’s going to be a lot of inflation.

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But that’s not what this theory is.

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That equation has 2 things in it that are under the control of policy.

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B, nominal debt, that’s determined by current nominal deficits and, of course, whatever debt was carried over from the past.

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And future primary surpluses.

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Those are both things controlled by policy.

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Furthermore, as I said, if there’s long-term debt the value of the long-term debt can fluctuate with the interest rate.

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So there’s another variable that’s left out of the equation as I wrote it.

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Here we’ve got nominal debt as if that’s a fixed number.

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But actually, if interest rates and expectations of future interest rates change,

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B can change without any deficit, because B is the market value of the debt.

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Besides the fact that it’s got 2 variables in it that are controlled by policy, it also has expectations of the future in it.

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One of the appeals of MV = PY as a nice simple theory is it's mechanical, all the variables in it are dated today.

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It doesn’t get to be complicated unless you really start thinking about what determines V and interest rates

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and start thinking about systematic effects of interest rates on velocity.

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But if you maintain the idea, well, velocity is going to be fairly stable anyway.

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You’ve got an equation that doesn’t involve thinking about the future in deciding about the price level.

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This theory says, what markets believe about future fiscal policy is central to determining the price level.

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So let’s start asking some policy-relevant questions of this theory.

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I’ll give you the answers.

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I won’t tell you exactly how you derive them, you’ll have to read the literature to understand that.

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But could debt accumulation lead to runaway inflation?

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This is a widespread fear.

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Many people look at quantitative easing.

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The policy in the US and Japan, and to some extent in Europe, of the Central Bank expanding its balance sheet

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by buying assets and increasing reserves as creating a risk of an explosion of inflation at some later point.

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Now, some of that comes from people who are monetarists and still think of reserves as high-powered money,

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without recognising the fact that interest is paid on them now.

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Which just breaks down the high-powered-money-multiplier argument.

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But some of it is from people who understand that if debt gets really high…

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Even if they’re monetarists, they may think the pressure from the fiscal authority to start expanding the money supply

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by buying government debt and holding down the interest rate might get to be very great.

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So the worry is that if deficits are large, debt gets big relative to GDP, we could end up with a lot of inflation.

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And the question is, is that a legitimate worry?

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Well, from the point of view of this theory it’s certainly something that could happen.

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It depends on if expansion of nominal debt is going to produce inflation.

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It has to be because the nominal debt is expanding despite beliefs about future primary surpluses not expanding.

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The future real primary surpluses must be holding fairly still while nominal debt goes up.

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If that’s true, then it will create inflationary pressure today.

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One way to think about that intuitively is:

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The government is putting into the hands of the public lots of debt that at current prices make the public richer.

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If nothing else changed that would make them want to spend more and would create inflationary pressure.

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If people believe though, that as this expanded debt gets into their hands,

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there is a corresponding expended stream of future primary surpluses that will back the debt, then they don’t feel any richer.

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They have bonds which are a positive entry on their personal balance sheets,

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but that’s offset by expected future taxes less expenditures.

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So they don’t feel richer.

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The notion that increased nominal debt leads to inflation depends on what people believe about future fiscal policy.

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And it’s unlikely that people’s beliefs about future policy are reasonably treated as invariant to current fiscal policy.

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So to get a theory of inflation out of this, you have to start asking,

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how the current policy decisions and current announcements about future policy affect markets belief about future fiscal policy.

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Monetarists - and in fact in this sense monetarists include the New Keynesians –

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they ignore the government budget constraint and this B over P equals discount at present value of tau equation.

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When they’re thinking about how inflation is determined, they ignore this part of the model.

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They set it aside.

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The equations from which this B over P equals tau over rho equation are derived

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just disappear from the New Keynesian models and from monetarist’s models.

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It’s not that the people using these models think those equations aren’t there.

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It’s that there are assumptions that are natural that make it possible to ignore those equations in determining the price level.

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The kind of assumption that makes it possible to ignore deficits in thinking about the price level

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is that every increase in debt today creates an expectation of increased primary surpluses in the future.

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So that increases in nominal debt don’t have any effect on the price level because they’re always balanced by people.

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When people see a big deficit today it makes them think there’s going to be increased fiscal stringency in the future.

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So they don’t feel richer.

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It might seem more plausible that if people see current deficits it makes them think,

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primary surpluses in the future are going to be less, or there might be deficits in the future.

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If that’s the kind of expectation, interaction there is between current fiscal policy and expectations of future fiscal policy,

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then debt expansion is inflationary.

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Now, another question on this policy issue is, could a Central Bank by being firm enough 'force' 'responsible' fiscal behaviour?

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That is maybe you could argue that it’s impossible for the fiscal authority to issue debt today

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without creating an expectation of future primary surpluses that back it so long as the monetary authority is firm enough.

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For example, that it’s committed to a fixed rate of growth of the money stock or even a fixed level of the money stock.

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I can’t explain it in detail; this requires going to these dynamic models.

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But it’s not true that there’s an asymmetry here, that the Central Bank can force the fiscal authority.

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Neither the Central Bank nor the fiscal authority can force the other one to do anything.

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It is absolutely true that if the monetary authority adheres to, and can adhere to, a fixed-money growth-rate rule.

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Or a rule that says interest rates are going to respond very strongly to inflation, so real rates go up when inflation goes up.

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If they have that kind of policy rule, then there is no equilibrium

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in which the fiscal authorities don’t back current debt with future primary surpluses.

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But it’s also true, if the fiscal authority doesn’t back current debt with future primary surpluses,

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there is no equilibrium in which the monetary authority maintains a constant money growth.

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There are no forces within the model

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that make one of those policies force the other policy authority to follow a different policy.

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It’s just that there are mutually inconsistent policies.

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If both authorities try to embark on these mutually inconsistent policies,

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the message of the theory is this situation will not last forever.

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The public knows it doesn’t last forever.

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That what actually happens now depends on beliefs about which authority is going to change policy when.

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And that’s all you can say.

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Another interesting implication of this theory is that if the public is convinced

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that deficits today do not imply surpluses tomorrow.

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That the surpluses tomorrow are stuck by, for example, a political process

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in which everybody can see that there is no way taxes are going to go up.

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And there’s no way expenditures are going to go down.

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We’re stuck with this particular stream of real-debt service and there’s political gridlocks, so that can’t change.

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If that’s true then when the monetary authority raises interest rates, it does not reduce inflation.

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Actually, the rise in interest rates, in that case with primary surpluses fixed,

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the rise in interest rates means that the conventional deficit, and hence the rate of issue of nominal debt, goes up.

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And the rise in interest rates is inflationary, not deflationary.

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There are actually time periods, and countries, where this has been front and centre consideration in monetary policy.

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In Brazil during the periods of high inflation, the monetary authority which already had interest rates in the 20% range,

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facing inflation in the 30% range, thought that it might be a good idea to raise interest rates to make the real rate positive.

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But they recognised that given the political situation, the rise in interest rates –

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because public debt was already very big, interest expenses a large fraction of the budget.

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The rise in interest rates would just increase the rate at which public debt was growing.

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And they knew this would be inflationary, not deflationary.

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This is a situation that’s easy to understand from the point of this theory.

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Very mysterious from the point of view of a pure monetarist view.

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But today I think in the US, Japan and Europe it’s not true that the public thinks that current deficits imply future deficits.

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In fact, the opposite is true.

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In fact, I think, even something worse than the opposite is true.

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People in the US, Europe and Japan are very aware that their ageing populations

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will require painful fiscal adjustments in the not too distant future.

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And that the political processes are not addressing these adjustments.

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The degree to which the political process is addressing these adjustments varies across countries.

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In the US it’s particularly depressing.

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How difficult it is to get any progress on resolving the issues of

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who is going to be hit, to what extent, by future fiscal stringency.

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Are the old going to have fewer retirement benefits?

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Are the young going to pay higher taxes, and if so how much?

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These are third rails in political discourse.

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Nobody wants to talk about them.

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In 2010 in the US 60% of non-retired people believe that social security, the main government retirement programme,

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would not exist in a form that would provide them any benefits then they retire.

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56% of people who are already retired and receiving benefits believe their current level of benefits would be cut.

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People are quite pessimistic about the future fiscal situation and its impact on them.

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With these beliefs, deficits that seem to arise out of crisis and political gridlock

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increase people’s uncertainty about who will be affected by future fiscal adjustments.

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And in my view makes deficits actually deflationary - actually, makes deficits reduce demand.

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People see their deficits.

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They already knew there were going to be budget problems in the future.

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They’re convinced that inflation will not occur.

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Part of this is that they’ve been very well convinced that Central Banks really can control inflation.

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And it’s been low and it will stay low forever.

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So these deficits are going to have to be covered.

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It already looked like I wouldn’t have any social security and my taxes would be high.

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This debt comes up so it looks like it’s going to be even worse.

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And furthermore I don’t know - if I’m young, is all the adjustment going to be on the young or is it going to be on old people?

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So the level of future fiscal effort is increased.

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And at the same time uncertainty about who is going to actually bear it increases.

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So the standard assumption in monetarist models, that lets people ignore the fiscal side in determining the inflation rate,

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seems to be more or less accurate for these countries that are now in slow growth, low inflation situations.

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And that’s a big problem.

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Because the way the monetary authority controls the inflation rate,

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if fiscal policy has this form where current deficits create expectations of future surpluses, is it moves the interest rate.

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So when inflation goes up, the way the monetary authority produces a uniquely determined price level

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and inflation rate is it promises that, if inflation goes up, it will raise interest rates even faster than inflation.

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So real rates will have to be higher if inflation is higher.

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And if inflation goes down it will lower interest rates even faster than the decline of the price level.

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And so real rates will go up.

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But all these countries are stuck at, or near, the zero lower bound.

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They have almost little or no room to make nominal interest rates go lower.

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The fiscal theory predicts that there is a class of equilibrium

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in which there’s a well-determined inflation rate in which the nominal rate is stuck.

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Contrary to what you’ll see in most textbooks, it is possible for the monetary authority to decide to just peg the nominal rate.

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And this does not lead to chaos or terrible equilibrium.

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What it does is transfer the determination of the price level from the monetary authority to the fiscal authority.

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If the monetary authority fixes the nominal rate, the price level is then determined by the fiscal authority.

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Assuming the fiscal authority does not follow the rule of making real future primary surpluses respond to the nominal debt.

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But instead follows a rule that says they’re committed to a fixed path of future primary surpluses,

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regardless of what happens to the current nominal debt.

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With that kind of fiscal policy you get a well-determined price level and inflation rate,

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in which you get something like the monetarist theory with B determining PY.

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But that’s not the situation we’re in.

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The situation we’re in is one in which the public thinks that current deficits correspond to future primary surpluses.

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And this theory says that if you have that combination of policies,

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the public believing that current deficits imply future primary surpluses, in other words future fiscal stringency.

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And at the same time interest rates can’t follow the inflation rate down, because they’re stuck at zero.

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Then, the theory says, the price level is indeterminate; it can do essentially anything.

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In fact, the theory says it will tend to drift downward stochastically.

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But the current price level is indeterminate.

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Of course, this is on the theory that this situation, this policy combination is going to last forever.

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If you say it’s only going to last a long time, then what happens today depends on beliefs about

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how long that time is and what policies revert to when that time is over.

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But that’s just another way of saying it’s very hard to say what the current inflation rate is going to be

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when current policies configuration seems to be in this form.

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And, unfortunately, this prediction of the theory looks uncomfortably like what we have seen in the US, Europe and Japan.

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Long periods of interest rates stuck at almost zero.

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And inflation, despite attempts at innovation by Central Banks,

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inflation not really doing what Central Banks would like to see it doing.

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Central Banks would like to see an average positive inflation rate of 2% or so a year.

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They’re not seeing it.

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In Europe it keeps going down instead of up.

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Central Banks undertake policies that amount to saying they are going to issue one kind of interest-bearing government debt,

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interest-bearing reserves, in order to buy another kind of interest-bearing security.

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Until you get into complications like risk aversion and stochastic modelling, these models suggest

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that this kind of policy of the government buying one kind of security for another is not going to have any effect at all.

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It’s not going to affect private budget constraints.

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So from the point of view of this theory, quantitative easing is a very weak policy.

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An attempt by the Central Bank to do something in a situation

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where what it would like to do and ought to do is get interest rates into negative territory, but it can’t do that.

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And fiscal policy, unfortunately, remains in a configuration where people think

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that deficits are going to be financed by future taxation.

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So is there an exit from zero lower bound?

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Yes, it’s easy to describe, but not easy to implement.

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It requires fiscal policy that’s expansionary now,

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without a commitment to cut future expenditures or raise future taxes to preserve current price stability.

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But, unfortunately, people are very convinced that that’s not the kind of fiscal policy we have.

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And it would require a major shift in the thinking of policy makers

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and the speeches they make to get people convinced that this is what’s actually going to happen.

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And furthermore it requires the political system to make commitments across time and stick to them,

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which is very hard for politicians.

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So I have just a couple of slides about Europe.

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The simple fiscal theory assumes one government issuing debt denominated in the currency of that government.

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A government like that never has to default.

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So the theory doesn’t discuss default.

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European fiscal authorities do not issue debt in a currency they control.

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Their sovereign debt has defaulted recently and is still considered defaultable by markets.

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At least if you look at the same kind of security denominated in Europe, as different interest rates –

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depending on what country issues it.

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So we don’t have time to elaborate the theory to cover default in multiple fiscal authorities.

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It gets a lot more complicated.

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But here are just a couple of the implications.

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The EMU was set up with the mistaken idea that it was possible to completely separate monetary and fiscal policy.

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But every monetary policy action has fiscal implications.

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That a commitment by the ECB to thwart speculative runs on European Union sovereign debt

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creates fiscal risk via a potential need for capital injection into the ECB, has become evident.

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If they bought a lot of sovereign debt of southern European countries, there would be a possibility this wouldn’t succeed.

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If it didn’t succeed the debt might drop in value.

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The asset side of their balance sheet would go way down.

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This would impede their ability to fight inflation.

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So revulsion against the idea that ECB actions could create fiscal risk,

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and hence potential cross-country implicit fiscal transfers, has limited ECB policy in the crisis.

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The northern European countries recognise this as a possibility, that the ECB could take actions

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that would actually end up taking money from Germans and Finns and give it to those irresponsible Italians and Spanish.

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And that has created resistance.

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And without fiscal backing, if there were not agreement by the European Union members to recapitalise the ECB

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if it really needed it, it’s possible that combatting a speculative attack could put the ECB’s balance sheet at risk.

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This is a very low-probability event.

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But it is non-zero probability.

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And in that case it would require a fiscal injection.

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And that would be an implicit transfer across governments.

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And no single government in the EMU can make the kind of expansionary fiscal commitment

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that I described would be necessary to get out of the zero lower bound.

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In the US it seems very unlikely that that will happen, but we know what would need to be done and who would need to do it.

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It’s not clear in the ECB that we would.

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So a combination of fear of inflation, fear that the ECB could be forced to inflate or allow inflation

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because it didn’t have fiscal backing, and an incomplete set of fiscal institutions

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could leave Europe in an environment of low inflation or deflation for a long time.

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So I'm done.

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(Applause)