How Inflation Radically Changes Economic Ideas by John Cochrane

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The unexpected resurgence of inflation demonstrates that the consensus ideas of economic policy are wrong and need to change.
The “new” ideas needed are characterized as well tested and available: supply-oriented, incentive-focused, and fiscally prudent policies.
Inflation comes when aggregate demand exceeds aggregate supply.

Fiscal expansion as a primary source of demand:
- The US government sent about $5 trillion in checks to people and businesses.
- $3 trillion of that was newly printed money, with no plans for repayment.
- Other countries enacted similar fiscal expansions and reaped inflation in proportion.
Supply considerations:
- Supply did shrink during the pandemic, but inflation spiked after the pandemic was largely over.
- Many “supply shock” industries were producing as much as before but could not keep up with demand.
The precise share of inflation from demand versus reduced supply matters little to the core lesson: supply (productive capacity) is far more limited than previously thought.

A supply-limited economy requires supply-oriented policy, not stimulus.
Jobs characterized as make-work are a cost, not a benefit, when unemployment is low:
- US unemployment cited as 3.7 percent.
Policies and reforms advocated to increase productive capacity and incentives:
- Reduce regulations that make housing costly and time-consuming to build.
- Implement a coherent immigration system to bring in workers who produce and pay taxes.
- Invest in public infrastructure, but be mindful of “obscene excess cost.”
- Eliminate tariffs that force overpayment for goods foreigners can provide more efficiently.
- Focus redistribution policy on incentives that promote growth.

The view of unlimited demand for government debt has proved false:
- The US, UK, and Europe seem to be able to borrow about 100 percent of GDP.
Consequences of more debt:
- More debt leads to higher interest rates, trouble borrowing, and inflation as people try to spend the extra debt rather than hold it.
Governments must spend as if they have to raise taxes to pay for it, now or later.
Projections that debt will serenely grow to 200 percent of GDP under primary deficits that are eternally 5–10 percent of GDP will simply not happen.
Fiscal capacity is diminished for future shocks:
- If the $5 trillion pandemic response was more debt than people will hold and caused inflation, the $10 trillion response to the next crisis will face even more trouble.

Left-wing proposals: spending trillions on cost-ineffective climate subsidies (example given: massively oversize electric cars built in the US, by union labor, with US parts).
Right-wing proposals: spending trillions on protection and industrial subsidies to revive 1950s manufacturing.
Warning: industrial policy risks repeating harmful effects (example: Jones Act parallels), and now that money is no longer free, spending must be effective.

Two deep lessons for monetary and financial policy:
- Central banks do not entirely control inflation; inflation control needs fiscal probity as well.
- The fiscal blowout included a financial bailout of Treasury, municipal, and corporate debt; money market funds; airlines; and others.
The “no more bailouts” promise of Dodd-Frank failed; extensive regulation (another 100,000 regulations) is unlikely to solve the underlying issues.
The proposed solution: return to the classic vision of equity-financed banking.

Progress in economics comes from patiently worked out, empirically verified answers that simplify reality into actionable cause-and-effect statements—not from ad hoc “novel” ideas or political demands for the appearance of novelty.
The mantras of the 2010s—“secular stagnation,” “modern monetary theory,” “stimulus”—are deemed invalidated by recent inflation outcomes.
Historical perspective: Adam Smith’s ideas, described as 250-year-old, remain relevant and informative for current policy debates.

Source: How Inflation Radically Changes Economic Ideas by John Cochrane, F&D Magazine, March 2024.

How Economics Must Change — John H. Cochrane
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