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Culture War Roundup for the week of March 18, 2024

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The causes of inflation

Having recently finished Cochrane's Fiscal Theory of the Price Level, I was primarily struck by how contrived all modern macro-economic models are, whether Monetarist, New Keynesian, or Fiscal. New Keynesian models, for example, imply bizarre outcomes such as spiraling deflation when interest rates are at or near zero, yet rather than discarding the model economists instead warn of spiraling deflation at the zero bound. From a methodological standpoint, there appears to be a tradition of "fixing" a model by declaring a variable to be stochastic or subject to regime-change; yet without going back and re-deriving the model with these additional assumptions. Dynamic Stochastic General Equilibrium (DSGE) models jointly estimate macro-economic variables and policy parameters, despite policies being a choice; rendering predictions of potential policy impact on relevant economic variables futile.

Indeed, I posit that all three frameworks are missing a key element that drives inflation: the fact that the representative inter-temporal discount factor is non-constant, and that the discount factor is directly impacted by fiscal policy.


First, some background. The representative agent (let's say me) prefers consumption now than consumption in the future. There are many philosophical reasons that this may be so, but the existence of debt appears to be ample empirical evidence for this assumption. The amount by which I prefer current consumption to future consumption is called the "discount factor", and can be modeled in a variety of ways. In discrete time, it is often symbolized using the Greek letter "beta" (not to be confused with the CAPM beta) and is typically somewhat less than 1 (perhaps in the .85-.99 range). Micro-economic models call the rate at which I prefer current consumption to future consumption the "elasticity of inter-temporal substitution", and typically model the impact of interest rates on this inter-temporal substitution effect. In equilibrium, the interest rate is directional proportional the negative log of the discount factor: r = a - log(beta), or if beta is modeled as exp(-delta), r = a + delta.

In a simple economic model with no government spending, no Federal Reserve, and no banks (frictionless financial markets) (and oh, to live in such a world!), the discount factor is directly related to the savings rate and amount of investment in "physical" (though intangible in the case of software and innovation) capital. Having a long term view implies a high savings rate. Savings are invested in capital. Capital is the primary driver of long-term economic growth, as it allows economies to produce more goods with greater efficiency. If the aggregate discount factor is at .95, then any capital investment with a (risk-adjusted) return greater than 5% would be financed, leading to more economic growth than if only capital investments with returns greater than 10% were financed.

Government spending, a central bank, and retail banks throw this simple model into flux. Unlike mutual funds, which act as a true intermediary by taking investors money and directly putting the money into portfolios of stocks and bonds, retail banks lend "safe" and thus cheap deposits. This cash has to go somewhere, and eventually makes its way back to a bank as a deposit...which is then lent out again. This cheap borrowing, and subsequent rise in the broad deposit base, artificially lowers the lending rate. Austrian economics correctly states that this leads to over-investment: investment is unbacked by corresponding saving, causing a bubble and mis-allocation of economic resources. A much more economically straightforward approach (and one also suggested by Cochrane) is for banks to be financed entirely by equity: investors can buy stocks in a bank, who then uses the money raised by an equity issuance to fund lending. This approach would let retail banks truly act as intermediaries, being rewarded for expertise in credit risk management and identification of wise investments, without introducing investment distortions.

Government spending is also a distortion. The government has to spend on something: either they hire private companies (a form of consumption or investment, depending on the nature of the spending) or directly create consumer or investment goods. Since this investment is also not tied to savings, distortion is introduced (Ricardian equivalence not-withstanding).

Finally, central banks control the interest rate either via the rate at which they allow retail banks to borrow or by directly creating money and purchasing government bonds on the open market. Purchasing government bonds increases the demand for bonds directly, giving the government more capacity to borrow and spend and facilitating more distortion.

Mainstream theories

Monetarists, New Keynesians, and Fiscal theories are aware of all the above, yet don't directly introduce these facts into their canonical models. Loosely speaking, Monetarists consider inflation to be driven in the long run by changes in the money supply: "Inflation is always and everywhere a monetary phenomenon" according to Friedman. Mathematically, MV = PY, where Y is economic output, P is the price level, M is the money supply, and V is the velocity of money (how frequently it changes hands). Under the assumption that V is a stationary process (conceptually, mean reverting) and that Y is long-run exogenous, the only impact on P comes from M. Unfortunately, M is not well defined, especially, as Cochrane correctly points out, in the presence of increasing financial innovation and removal of financial frictions. If I can purchase a television by an immediate transfer from my investment portfolio with no conversion to cash, then M is not only all cash and deposits, but also all bonds and stocks. Central bank open market operations, where money is created to purchase bonds, then has no impact on the money supply. Cash is created, but bonds are removed from the market, which is net-neutral for the money supply.

New Keynesians, in the tradition of the original Keynesians, consider inflation to be caused by excess demand. This is explicit in their canonical models, where the inflation rate is a function of the output gap and expected future inflation. New Keynesian theories struggle to explain the lack of inflation from 2009 to 2020, where fiscal and monetary policy were both accommodating, but in which inflation stayed stubbornly low.

Finally, Fiscal Theorists consider inflation to be the result of government deficits that are not backed by corresponding future surpluses. In this theory, government debt is valued by the present value of future primary surpluses (cash flows excluding interest expenditure). Government can either credibly promise to pay back new debt (in which case the current value of debt remains constant), or the price level will increase to deflate the current level of debt. This theory is relatively simple and has many advantages that Cochrane articulates in detail. My biggest issue with the theory is that the mechanism for inflation is opaque. The government can issue debt and promise future surpluses, leading to Ricardian equivalence. But if the government doesn't promise future surpluses, people are free to spend the money, driving up the price level. This theory does not, to my knowledge, tie consumer behavior back to the representative agent's utility function.

What about the discount factor?

And now I can finally get back to my own theory. Each of the three theories posited above assumes that the discount factor is constant. I believe that the discount factor is dynamic and that this dynamism directly leads to inflation. Fiscal policy can directly impact the discount factor, while monetary policies can stimulate inflation by decoupling interest rates from the discount factor.

An immediate shift to higher discount rates (lower discount factor) will cause immediate price level increases. As I now prefer current consumption even more over future consumption, I will spend more today and save less for tomorrow. Since higher discount rates lead to less economic growth, there is less room for supply side easing of inflationary pressure. Populations that have higher discount rates will also tend to vote in myopic governments who focus on short-term benefits while ignoring long-term structural and financial concerns.

Expansionary fiscal policy puts additional cash in consumers or investors hands. The presence and continued growth of additional cash will have an impact on savings rates: why should I bother to save if I will simply receive more government cash in the future? The discount rate will rise as a result. Cochrane does have a point: debt that is backed by future surpluses will not have the same impact on the discount rate, since eventually the gravy train will stop. However, Cochrane does not allow discount rates to change, robbing the model of a key mechanism for inducing inflation.

Expansionary monetary policy does not necessarily impact the discount rate. While in a frictionless society with no government, an interest rate decline can only happen when discount rates also decline, in an expansionary monetary episode lower interest rates can lead to higher “real” discount rates. The availability of cheap money relative to discount rates leads to increases in borrowing and current consumption which leads to demand-side inflation. This is a standard Keynesian argument, but I go one step further: long periods of low interest rates can lead to a lethargic population that assumes that money will always be free. How this manifests in a utility function is ambiguous: it could be that this actually lowers the discount rate in the long run (raises the discount factor). If this is the case, then a sudden interest and fiscal shock to the system can causes an even larger increase in the discount rate.

2021 was a time of fiscal excess, supply shortages, and post-pandemic YOLOing. Discount rates shot through the roof, as evidenced by both heightened consumption and declines in workforce participation, hitting both the demand and supply side of the economy, funded by accommodating fiscal policy. It is a testament to the American people that we seem to a large extent to have come back to our senses. Despite continued deficits, inflation has come down as the discount rate has dropped to near previous levels. However, it is clear how easy it would be to devolve into a South American-style economy, characterized by short-termism and fiscal irresponsibility at both the individual and government levels.

Why is this culture war material?

To what degree are low discount rates driven by culture? Americans were originally positively selected for long-termism. By definition, they had an unusually high capacity for adventure, exploration, hard work, and desire to create a better world for their descendants. Most of the immigrants to the United States since have had similar positive selection. Even the Irish and African populations, who may have been negatively selected on certain attributes (by the potato famine and by defeat/capture by rival tribes respectively), there isn't anything to suggest that their discount rate was negatively selected for. When America was a melting pot, they were assimilated into a culture that favored long-termism.

When considering modern immigrants in light of discount rates, I come to a surprising conclusion. Whatever issues illegal immigrants have (and I have many concerns!), they may well be positively selected on discount rate. They risk danger and uncertainty for a better and brighter long-term future. On the other hand, while seemingly the most successful immigrants, Indians could very well be negatively selected on discount rate. Rather than stay in India and help transform it into a fully developed nation, they come to the United States to enjoy immediate success. Indians (Brahmins) have administrative and managerial talents that often far outpace the mean American and they enjoy great success navigating the PMC (the growth of which could also be a consequence of higher discount rates). Yet in my experience, these high-capacity Brahmins do not actually drive innovation or change. If I'm correct about this, the current surfeit of Indian executive talent could contribute to American economic stagnation.

I want to congratulate you on writing one of the greatest motteposts of all time. 2000 word summary of different economic schools of thought, mostly correct (econ major, can confirm, though your notion that discount factors are assumed constant is not necessarily so in the schools you ascribe it to), followed by 500 words of "Actually, Scientific Racism would explain this better".

Truly an quintessential example of a mottepost. Showcasing that you've done the work to at least try to understand modern scholarship, but discarding it in favor of whatever flavour of phrenology is in this week.

I can't imagine a better example of a mottepost.

  • -10

I can't imagine a better example of a mottepost.

Then read some of the better ones. I could as easily say your post is a classic sneerclub post: full of sneering condescension that exhibits a surface-level appreciation of someone's point but then reduces it to an uncharitable straw man.

It's been 11 months since you caught your last ban. Maybe you've been on vacation since then, but if you haven't mellowed after all, then just to let you know, if you decide you're going to flame out in one last hurrah, I will not only ban you permanently, as I promised, but I will take the rare step of deleting your post to deny you the satisfaction of getting your last digs in.

Or, you know, you could try participating in good faith. Just a suggestion.

I don't think that it's fair to describe the whole post as racism. There is more of general conservative vibe to it(the past was better and you should invest in your country). And also obviously Austrian school signs all over it.

See, to me this feels odd because it leaves out one crucial point. People being primarily motivated by social status. It's not, why should I bother to save if government money is coming in the future? It's why should I bother to save if I'm going to take a significant hit to my social status and image today? Lockdown and stimulus basically served as a sort of supercharger for this competition. People are not going to like the solution however, which is essentially that the middle class/upper middle class has too much discernable income, and probably should be taxed significantly more.

That was Robert H. Frank's argument for a steeply progressive consumption tax. It would reduce zero sum status competition while keeping savings/investment high.

I was primarily struck by how contrived all modern macro-economic models are

1000 times yes. I have a BS in economics. Macro still seems like voodoo magic to me. The only model I sort of like is the "sustainable patterns of specialization and trade" kind of model.

[discount rate]

Do you not think the discount rate stuff was sorta covered by the OG Keynesian "animal spirits"?

I get the sense that they kind of figured this out, but economists just really don't like having an unmeasurable thing in their models. Much of the modern profession is filled with math nerds who earned their PhD by doing some fancy math manipulations on theoretical and completely impractical models. The economists that prefer to actually model the real economy get paid the big bucks on wall-street.

I don’t think Wall-Street hirers those guys anymore. Maybe a Bill Gross or Gundlach but to be honest those guys spend probably more time think about small market structure edge to squeeze an extra 20 bps versus absolutely hammering the economic outlook right and getting 10 year up or down right.

The big macro funds are going to be thinking about a lot of other things too than getting the macro call right. The guys in those shops getting the economy right just isn’t that important when your levered and have risks limits on everything. Pays much better just figuring out a sentiment shift or a trigger for a price (like at etf entrance or some quant allocation that will happen).

Any macro interview is going to start with returns and Sharpe ratio stuff not whether your calls are right. Getting calls right is just too volatile.

One example I would use is when oil when -50 (and an extreme example) it only traded negative for like 90 minutes and the entire next day was positive entire day. Even if you knew the price next day and traded that you wouldn’t make money because is in between for those 90 minutes a nice security guard came to your desks and escorted you out. What happened is some Chinese banks were long some derivatives linked to that days oil close and blasted it negative (probably illegally) causing billions of losses on those banks. But if you had mapped out all the fundamentals and macro and absolutely nailed the value of a barrel of oil you would in fact not be rich.

The only place I think kind of sometimes takes a big macro swing (usually on bearish side) is Bridgewater but they overall haven’t had great performance but somehow are a marketing powerhouse.

On the mainstream theories

I don't see how the Monetarist model can be seen as contrived. It is the simplest model and the one most in line with standard economic principles without bells and whistles. All prices are relative and we can think of the "price" of money relative to other goods. Money is a (durable) good with well-defined demand and supply. (Sure, the demand and supply functions must be described in "real" rather than "nominal" terms, because dollars are valued according to what they can buy not just for themselves). Demand and supply determine the relative price of money. If supply is increasing relative to demand—a monetary expansion— the price of money will be going down and we have inflation. Granted, there are a lot of important details: what should count as money, how substitutable bank deposits and cash are, how should we aggregate them into a single composite measure of total money; but the core of the framework is just that. Just basic supply and demand analysis.

The New Keynesian model recognizes this, but it gets hidden in their "cashless limit" so that the standard textbook version has no mention of money quantities at all. But it is there in the background. The contrived parts of the New Keynesian model comes from their decision to select and rule out certain types of equilibria and not being careful with working directly with the limit version of the model rather than solving the model first and taking the limit later.

On the discount rate

The fact that the discount rate matters for saving decisions does not mean that the discount rate changes with the environment. If the government has some expansionary fiscal policy, my budget constraints will change and I might substitute consumption intertemporally even if my discount rate is the same.

In the theory of (consumption-based) asset pricing, economists generally talk about the stochastic discount factor which takes into account the marginal utility in the future (in the different possible futures, hence stochastic). For instance, changes in this stochastic discount factor are used to explain the changes in the value of the stock market. But the idea there is that my rate of time preference between 1 utility unit today and 1 utility unit tomorrow remains the same, I just have a different rate of preference between 1 unit of consumption today and 1 unit of consumption tomorrow. If this is your point, then it makes sense. But it is not a point that is missed by the mainstream theories, it is literally taught in the first-year classes of any mainstream school.

Austrian economics correctly states that this leads to over-investment: investment is unbacked by corresponding saving, causing a bubble and mis-allocation of economic resources.

I was waiting for this. The rest of the post prior has all of those usual """dog-whistles""" that it was like a twist in a movie you can see coming from miles away.

Is it 2008 again? I remember the internet being full of this kind of thing (and being one of the contributors!).

Anyway, it's important to point out that 'full reserve' theorizing is not 'Austrian' economics, it's Rothbardian Austrian economics. The original ABCT doesn't require it to avoid business cycles and Hayek's formulation can be re-cast in essentially monetarist terms as about the interplay of the supply and demand for money without much modification. The supply of loanable funds (a nominal quantity) does not necessarily represent the full production possibilities of the underlying economy (a real one). That is, there are 'real' savings that are not represented by nominal savings at a given price level/quantity of money. The demand for money will be driven, in part, by the investment possibilities created by real savings, so a full reserve banking system will under invest in production, while the fractional reserve system the Rothbardians are against would be able to invest enough for the economy to reach its production possibilities frontier without going beyond it and generating a business cycle.

As to the rest of your post: a lot of what you're talking about with population discount rates would probably be covered in post-war Keynesian literature on the propensity to save/consume. The empirical validity of a lot of it varies, I'm sure, but I can't imagine it's any more questionable than your last two paragraphs.

You are reading too much into what I wrote. I am not Austrian. 100% reserves will not resolve business cycles, nor is that prescription practicable. I think even the New Keynesians have more interesting things to say on economics than Austrians. I happen to work for a large-ish bank that practices fractional reserve banking (as all retail banks do), and I can sleep at night.

I think Cochrane is the closest to being correct of the three that I laid out. I also think his proposal for 100% equity funded banks is both practicable and better aligns savers and borrowers, and will definitively end bank runs. I think all three are closer to being "correct" than the Austrians, whose main claim to fame is thoroughly debunking Marxist economics (admittedly not a high hurdle to clear).

I would love to hear more from you on the post-war Keynesian literature and how it is relevant to the rest of my post; that is the part that actually interests me.

The supply of loanable funds (a nominal quantity) does not necessarily represent the full production possibilities of the underlying economy (a real one). That is, there are 'real' savings that are not represented by nominal savings at a given price level/quantity of money.

From within the Austrian framework, I think this claim does not hold. I think what you are saying—and please correct me if I’m wrong—is that there may exist savings held (e.g.) in the form of dollar bills in a deposit box at a bank. These bills cannot be lent out as part of the bank’s operations, and hence the real wealth which they represent can never participate in the economy as “investment”.

However, an Austrian would say that those dollar bills are not savings in the sense of forming part of the supply of loanable funds. Savings-as-loanable-funds are a subset of savings-as-deferred-consumption; the former entails the assumption of some risk, while the latter (as in the case of bills in a deposit box) need not.

If you like, holding money qua money, rather than allowing it to be lent out for investment purposes, could be called “exercising demand for money” or less charitably, “hoarding money”, as distinguished from “saving”. An Austrian would say that such hoarding is economically no different from exercising demand in any other way (e.g., through consumption of real goods/services).