Not Another Investment Podcast
Understand investing beyond the headlines with Edward Finley, sometime Professor of Finance at the University of Virginia and veteran Wall Street investor.
Not Another Investment Podcast
Fed Independence, Fiscal Reality (S3, E1)
Think the Fed can always tame inflation if it just hikes a little harder? We sat down with economist Eric Leeper to unpack why that story falls apart once you account for Congress’s power over taxes, spending, and debt. Eric explains operational independence in plain terms, traces how the modern central bank mandate evolved, and shows why economic outcomes depend on both monetary and fiscal choices—especially when higher rates swell interest costs and the bill gets rolled into more borrowing.
We walk through the fiscal foundations of inflation: $40 trillion in government liabilities backed by the expectation of future primary surpluses. When those expectations wobble, the price level does the adjustment. That lens reframes the 1970s and Volcker era, highlighting the fiscal steps that helped disinflation succeed. Fast forward to today’s 100 percent debt-to-GDP world and the signals are harder to ignore—tailing Treasury auctions, a tilt to shorter maturities, and foreign buyers stepping back. Eric connects those dots to fiscal dominance, where rate hikes can perversely fuel inflation by making bondholders feel richer, forcing the Fed into a damaging loop of ever-tighter policy and ever-rising debt service.
So what actually works? Eric outlines a pragmatic Plan B for central banks when Congress won’t deliver credibility: prioritize smoother, more predictable inflation paths, reduce policy whiplash, and communicate the fiscal conditions required to reclaim durable price stability. Along the way, we revisit the “Hamilton norm,” examine the UK’s 2022 market shock as a cautionary tale, and challenge the idea that inflation control lives only at the Fed.
If you care about markets, policy, or your portfolio’s real returns, this conversation offers a clearer framework for what moves inflation—and who must act to anchor it. Subscribe, share with a friend who loves macro debates, and leave a review with your take on the best path back to stability.
Thanks for listening! Please be sure to review the podcast or send your comments to me by email at info@not-another-investment-podcast.com. And tell your friends!
When the government pumps too many bonds into the economy, it's gonna cause inflation. And I don't know why we got rid of that feeling, except I blame Milton Friedman.
SPEAKER_02:Hi, I'm Edward Finley, a sometime professor at the University of Virginia and a veteran Wall Street investor, and you're listening to Not Another Investment Podcast. Here we explore topics and markets and investing that every educated person should understand. Be a good citizen. Welcome to the podcast. I'm Edward Finlay We've got a terrific episode for you today and a terrific guest to match. Today we've got uh Eric Leaper, who's a professor of economics at the University of Virginia and a research scholar at the Mercatus Center at George Mason University. Eric's work focuses, he's a macroeconomist, and his work focuses on monetary and fiscal policy. He began his career at the Federal Reserve Board in the United States and has for a number of years been an advisor to the Swedish central bank as well as central banks all around the world. Eric, welcome to the podcast.
SPEAKER_00:Thank you. Happy to be here.
SPEAKER_02:So, you know, if you are paying attention to the media these days, you read a lot of headlines that talk about the Fed's independence and the crisis that political events might be causing in the minds of those who think that the Fed's independence is at risk. We hear that the Fed is trying to fight inflation, the Fed is busy doing the things that we need them to do, and the president needs the Fed to lower interest rates and is going to do anything he can to affect that result. Eric, it's really hard for any of us mere mortals who sit reading the paper to understand that in any way except a political way. And I'd like you to help me talk my listeners through what's really at work here and how we should think about it as we participate in that conversation. And I'd love for you to start me off with the idea about this notion of Fed independence. Tell us a little bit about why do people first, what is the what is it? And then second, why are people so animated about it?
SPEAKER_00:Aaron Ross Powell Well, I have maintained for quite a long time that we should never use the word independence without a modifier. And the reason for that is that I think using the term alone leads to some pretty serious misunderstandings about how the economy works. Aaron Ross Powell So the idea of independence is really about operational independence. What that means is that the Fed should be able to set its policies, which could be interest rates, it could be asset purchases, whatever it is that the Fed is doing, without any interference from Congress or the President. Trevor Burrus, Jr. Why is that useful? Trevor Burrus Well, because what we have found through many centuries is that there is always a very powerful temptation for sovereigns to use inflation to finance their spending instead of using taxes. And inflation, I think Ronald Reagan said, uh, is the cruelest tax of all. It's the one that nobody votes for and everyone pays. And that's part of why it's appealing to the sovereign, because it has this sort of diffuse effect across the economy. And so getting back to that point, that's why it's essential for central banks to be operationally independent. Now, the problem is that it's too easy for that modifier to get dropped. And then we start to think, oh, well, that must mean that the central bank is omnipotent. It can achieve whatever it wants to achieve, because after all, it's independent. And what that fails to acknowledge is that it is not ever economically independent. The outcomes in the economy always depend jointly on what the central bank does, monetary policy, and what the legislature does, fiscal policy, taxes, and spending.
SPEAKER_02:What do you think drives that common misconception that the Fed's independence is so crucially important and they think of it as economically independent? What do you think drives that misconception?
SPEAKER_00:Aaron Ross Powell, I think a lot of it has to do with how we have created our policy institutions. And so the way we have done it, which is the way a lot of central bank, a lot of countries have done it, is we create this so-called independent central bank, we give them the task of controlling inflation, and then we act as though what the legislature does has no bearing on inflation. And so it's easy to slip into this idea that, well, by law, the Fed controls inflation. Ergo. That's how it works in the economy.
SPEAKER_02:Trevor Burrus, Jr.: I see what you mean. Like it's easy to see how democratic institutions would, if left to their own devices, really pay very little attention to the impact the fiscal policy has on the broader economy, and if there's a way to create another entity that's, quote, independent that takes care of inflation, I can see the danger there. But I'm curious whether that was a reason for the Fed's independent. Like in other words, am I being too cynical? Did they sit around saying, ha ha, what we'll do is we'll create this quote unquote independent Fed, and that will let us do whatever we want. Uh we have somebody convenient to blame? Is it a straw man?
SPEAKER_00:Well, I think a little bit of history here is helpful. When the Fed was first founded in 1913, it was put in place to address financial crises. We had one after another. And so the idea was that you needed some entity to provide liquidity to the financial system to avoid the kinds of crises that we went through over and over again in the 1800s. It wasn't until about 1951 that the notion that the Fed ought to be independent came about. Before that, in fact, from the time of Roosevelt all the way through World War II, the objective of monetary policy was to keep interest rates low. And in fact, it was explicit during World War II that that was to help finance the war and make it cheaper for the government to borrow. And then we started to see that, well, gosh, inflation's kind of high. Maybe we need to uh Is it in the fifties? Trevor Burrus, Jr. Yeah. In the early well, late 40s, early 50s. Trevor Burrus, Right. Maybe we ought to let the Fed do something about that. The modern notion of independence, I think, really didn't. I mean, it sort of started it with the Fed Treasury Accord in 1951. But this idea that we need to put this control of inflation in the hands of technocrats, I think that really didn't take off until probably Paul Volcker's time.
SPEAKER_02:Aaron Ross Powell So the rapid massive inflation of the 1970s and Volcker's having to really pull the handbrake essentially. So okay, that so that makes some sense to me. Help me and help the listeners understand with respect to the operational independence of the Fed, should we be concerned about the President's recent steps to have one governor removed? He was able to appoint a new governor for someone that left the board, the chair is scheduled to be replaced. Talk to us a little just in a very basic way about the mechanics of how the Fed works with respect only to its operational independence. What kind of risk is there? Is that something we should be engaged in thinking about critically?
SPEAKER_00:Yeah, I think that's a really big deal. Part of the idea of the structure of the Fed was that governors were given 14-year terms. And on top of that, so that's at the Federal Reserve Board. And on top of that, we've got 12 semi-private institutions called regional Fed banks. And the presidents of those banks are appointed by the boards of directors at those banks. So the original idea was that we wanted to have diversity of thought. We wanted them to be able to represent their constituents who are in their districts.
SPEAKER_02:Aaron Ross Powell I suppose it also reflects the fact that the country is not one economy, that there's lots of kinds of economies that make up what we are here. And maybe those 12 banks. Is it true that they were sort of the maps were drawn in such a way as to reflect different types of economies?
SPEAKER_00:Aaron Powell Yes. And it also to reflect the fact that in 1913 we had a lot of farmers. That's why we've got a Kansas City Fed and a St. Louis Fed and a Minneapolis Fed and a Cleveland Fed and so forth, but only one Fed out in California, in San Francisco. So there's a lot of sort of history dependence in that. But what I wanted to get at was that you've got these Fed governors who have long terms. 14 years is well beyond any term that a president can have. You then have these regional Fed presidents who aren't appointed by the U.S. President. I should have made clear that the governors of the Board of Governors are appointed by the President and then approved by the Senate. So they are political appointees. Regional Fed presidents are not. So this is all designed to give the central bank a longer perspective than, say, politicians have. Politicians' time horizons are about 20 minutes. And presumably the Fed uh has a much longer horizon. It's perhaps not as long as I would like it to be, but it's still on the order of years rather than dates.
SPEAKER_02:Trevor Burrus, Jr. So structurally, the Fed is organized in a way to be responsive, it sounds like, to a few different pressures. It's structured to be responsive to the needs of different types of economies in the country. Those regional Fed banks you described as quasi-independent, they have their own boards of directors, which presumably means they're responsive to, say, leaders in those communities and in those industries. And then you've got the Fed Board of Governors appointed by the President with the advice and consent of the Senate. So they're nationally responsive to the executive, but also to the Congress. Super. Functionally, I mean again, I want to just stay with the operational independence. Functionally, then for listeners, how does the Fed do its job? What's the like are all of those governors and all of those Fed presidents coming together and deciding by committee, or how do decisions get made?
SPEAKER_00:Aaron Powell The decisions get made by the Federal Open Market Committee. And that consists of all the governors. The New York Fed president is always on the FOMC. And that's because New York is where the actual financial transactions that the Fed undertakes take place. And then other regional Fed presidents rotate onto the committee. And so the idea there is that the composition changes over time, but it uh it has a certain consistency because the governors and the New York Fed President are always on it. Trevor Burrus, Jr.
SPEAKER_02:And so when when we're when we're focusing on its operational independence, if the if the President of the United States is able to replace three of the twelve governors, got that right?
unknown:No, no, no.
SPEAKER_02:Six governors. Six governors. So in terms of this operational independence, if the President of the United States changes three of the six Fed governors, that's a pretty big deal when we read a headline that says the President has changed 50 percent of the Fed's Board of Governors. But in an operational sense, it's not perhaps that big a deal because we have the rotating members of the regional banks that are participating.
SPEAKER_00:What are we missing? Aaron Powell's a twist. Trevor Burrus, Jr. The regional bank presidents are come up for renewal and approval by the Federal Reserve Board. And so if part of the political strategy is to infiltrate the boards of directors at the regional feds, not unlike the way the administration has infiltrated boards of directors at universities, then they could end up not approving certain appointees and sending them back to the boards of directors.
SPEAKER_02:Okay, so it's a real concern, right? And that real concern from your point of view is that it compromises the operational independence of the Fed. What's the cost?
SPEAKER_00:Well, there are a couple of costs. But there's another cost, which is in terms of how the whole system works. That act tells the Fed what its job is. Its job is to stabilize inflation, to try to pursue maximum employment, keep interest rates low, it's sort of a bunch of stuff, and also uh ensure uh stable financial markets.
SPEAKER_01:Okay.
SPEAKER_00:So it's a big mandate. It is. And and what is this keep interest rates low part is usually just kind of set to the side because everyone understands that that can conflict with uh keeping inflation under control. So the the problem with what uh the President has been asking the Fed to do is that it conflicts with the fundamental objective, which is to keep inflation under control. You cannot control inflation and stabilize debt at the same time. In fact, the act of stabilizing inflation, and we saw this during COVID, inflation went up, the Fed raised interest rates dramatically. Those higher interest rates, because we had a 100 percent debt GDP ratio, very quickly manifested as ever increasing interest payments on the debt. Because Congress has not done anything to raise taxes or cut spending, those higher interest payments, which last fiscal year were to the tune of a trillion dollars, are getting financed by borrowing more. So government debt is starting to grow more rapidly. So let me just encapsulate that with a simple phrase, which is that the act of stabilizing inflation necessarily destabilizes debt. So if the Fed were to suddenly submit to the President and act in a way that keeps debt stable, and it would do that by dropping interest rates dramatically, then it's given up control of inflation.
SPEAKER_02:This raises a really good point. You uh I know you shared with me you have a forthcoming book uh titled Fiscal Foundations of Inflation, Seeing Beyond the Monetary Narrative. What I'm and it's terrific. I mean, it's a terrific read, and I think it lays things out in a pretty it's not a it's not a technical or a dense read. It lays things out in a pretty commonsensical way. But it it begs the question that I think you're hinting at here, which is we've come to think that the Fed and the Fed alone has the only levers to control or moderate inflation. Um there sounds like there's some good political reasons why we might think that. Um, but it isn't the whole story, it's half the story. So I'd love to sort of jump off then from what you just said and talk to listeners a little bit about what you mean by uh stabilizing inflation is destabilizing to debt. Walk us through in a basic way this interaction between the Fed's monetary policy and Congress's fiscal policy.
SPEAKER_00:Okay, well, let me first describe what I mean by the fiscal foundations. So the U.S. government now in total has liabilities circulating to the tune of about$40 trillion. So what am I including there? Well, currency, uh bank deposits, which uh bank reserves, I should say, which um are basically short-term borrowing by the Fed to the banking system, and then treasury securities, bills, notes, bonds. The vast majority of these are in dollars, and they are just promises to pay off in dollars. They're not promises about how many goods and services those dollars are gonna buy, i.e., not purchasing power. Uh they're just promises to dollars. So then you've got to ask yourself, well. Well, what gives these claims to dollars value? And that's where you have to then ask, okay, well, so what are the assets that are backing up those liabilities? Well, those assets for the U.S. government are what are called primary surpluses. Those are revenues minus spending, not including interest payments.
SPEAKER_02:Aaron Powell So basically, like how most households would run a budget. Trevor Burrus, Jr.
SPEAKER_00:It is exactly that. And the difference, though, between what are liabilities and what are assets is really important because the assets are if you look at our tax code, it's mostly indexed to inflation. So that's really, you want to think about that in terms of purchasing power. If you look at things like Social Security, that's indexed to inflation. In fact, the uh the government is now shut down. And uh we haven't been able to get employment numbers, but we will get inflation numbers, although late. And the reason for that is because of Social Security indexation. So they're gonna call in some employees to do that. Trevor Burrus, Jr. To compute it. They're considered essential workers now. That's interesting. So the point is that the assets are primarily in units of what we would call goods, whereas the liabilities are in units of dollars. Well, how are these things equated? Well, you have to convert those dollars into goods. You do that by dividing by the price level. So then you've got that the real value of those liabilities equals the real value of those assets.
SPEAKER_01:Got it.
SPEAKER_00:Trevor Burrus, and the important thing about assets is it's not just what is happening to the budget today, it's what do people think will happen to these primary surpluses all into the future, and then you discount that back to the present. Aaron Powell Sure.
SPEAKER_02:Because if like uh like anything, you know, listeners will remember a very early episode in season one where we talked about some very basic bond math. When we think about what a bond is worth, it's really a discount to those cash flows over time with a lump sum payment in the year of maturity. It sounds like you're suggesting we would think about it the same way. How good is the government for its promise? Look at what we think its future cash flows will be with a lump sum payment at the end.
SPEAKER_00:Right. And so what that gets you thinking about is well, gosh, these liabilities, yeah, some of them are controlled by the Fed. Now, we the Fed has a policy of just passively supplying whatever currency gets demanded. So that that really uh kind of gets set off to the side. The uh the bank reserves, which are now about$7 trillion, are controlled by the Fed. But the rest of it, which is 80 percent, is controlled by the Treasury and the and the Congress.
SPEAKER_02:Trevor Burrus, Jr. And that's because, let me make sure uh we're all getting it, that's because how much there is outstanding in Treasuries is simply a function of how much the government needs to borrow to keep itself running.
SPEAKER_00:Which then in turn depends on taxes and spending. Aaron Powell Gotcha. And so the bottom line there is that if you want to think about inflation and what drives the price level, which is you know, inflation is just the rate of change in that price level for the economy, you can't get around thinking about fiscal policy. And this notion that somehow a little tiny subset of those liabilities, i.e., say currency plus bank reserves, is what drives inflation, because that's what's controlled by the Fed is just completely at odds with how the actual economy operates.
SPEAKER_02:So you described uh you've described that in your work as the so-called monetary narrative. And so if I'm let me see if I can reflect it back to you, you correct me where I've gone wrong. The monetary narrative really is saying that by raising interest rates, the central bank can offset any fiscally induced demand that gives rise to inflation. How'd I do?
SPEAKER_00:Aaron Ross Powell That's certainly a critical element of the narrative.
SPEAKER_02:Aaron Ross Powell Got it. And that would you would you try to would you like to hazard a guess like where where's the origin of that narrative? Is it just coincident with the existence of the central bank? Is it something newer historically? Aaron Ross Powell Milton Friedman. Okay. I give it to Uncle Milty.
SPEAKER_00:Trevor Burrus, Jr.
SPEAKER_02:And what's that where's the what's the what's the power there?
SPEAKER_00:Aaron Ross Powell Well the the way that I describe the monetary narrative in the book is through seven propositions. And I'm going to just talk about two of them, which I think of as the mother and father. The mother proposition is Friedman's famous adage that inflation is always and everywhere a monetary phenomenon. Now it used to be that people thought about Friedman, for example, thought about some money supply as being the monetary phenomenon. And the Fed tried that experiment in the late 70s, early 80s to try to target the money supply, which is really mostly bank deposits and things of that sort that aren't directly controlled by the Fed. And that was a colossal failure. They discovered that it was very hard to try to hit a particular money growth rate.
SPEAKER_02:Well, it also sort of strains logic because I don't know much about this area, but what I do know is that banks lend, and when banks lend, they lend a multiple of what they maintain as deposits. And if they're lending a multiple of what they maintain as deposits, where's the additional stuff coming from? And it seems to me the banks have just made money. And so if you're only measuring the money supply with bank deposits, I suppose, provided that the person to whom you lend also deposits it, you're capturing it. But it sounds to me like that's just too simplistic an explanation.
SPEAKER_00:Yeah, I mean I think the beauty of it is its simplicity, and that's why it became so attractive. Because it was this notion that you could look at one market, the market for money, and have supply and demand in that market. And if you could somehow nail down what the demand is, then oh well, let's go ahead and assume the Fed can us can control the supply. Well, then we can hit any price level we want. Trevor Burrus, Jr. Okay. But fantasy. Aaron Ross Powell I think we discovered it was a fantasy. Trevor Burrus Okay. So then how did the monetary narrative change? Aaron Powell Well, they discovered that trying to target money was not going to work. And so it then morphed into the interest rate. The central bank controls in the United States it's the federal funds rate, which is the overnight interest rate at which banks can borrow and lend reserves. And that became the monetary narrative. So we have moved from something about money to something about interest rates. But the whole story didn't change after that. The transmission is very similar. The notion that this interest rate can always control inflation as the Fed desires isn't any different, really, than Friedman's you just change the growth rate of the money supply and you're done.
SPEAKER_02:But I mean, let me play your devil's advocate for a second. If the Fed raises interest rates substantially as it's just done, then one of the outcomes of that action is also going to be to make the fiscal authorities' debt a lot harder to manage, forcing them either to raise taxes, cut spending, or both. And so maybe could one say that there's a little bit of juice to the monetary narrative that you really can impose fiscal discipline through monetary policy, or is that too simplistic?
SPEAKER_00:Aaron Ross Powell Well I think there are instances where that has happened, and there are many instances where it has not. And uh so it's basically setting up a game of chicken. And some people describe what Volcker faced uh as a game of chicken. Aaron Ross Powell Okay. And but there's a there's a narrative there that makes it look like Volcker was completely committed to getting inflation down. He operated independently, he didn't pay any attention to the politics of the situation, and he single-handedly then slayed the dragon. Trevor Burrus, Jr. So goes the story. Trevor Burrus, Jr. So goes the narrative. And that actually is what I call the father of the monetary narrative. That if the central bank is committed and independent, it can always control inflation. Well, the only thing that's missing is the actual history. Trevor Burrus, Jr.
SPEAKER_02:The facts, you mean?
SPEAKER_00:Yeah. So in 1981, Ronald Reagan had his famous tax cut, which generated very large deficits. And Volcker was, unlike central bankers since him, very outspoken and very pointed about what it takes for him to be successful at controlling inflation. And he made it very clear that monetary policy alone cannot do the job. Trevor Burrus, Jr. Interesting. That gets lost in the story, doesn't it?
SPEAKER_02:Aaron Ross Powell A little bit. Trevor Burrus, Yeah. I mean, I don't think I've ever heard that part of the story. Trevor Burrus, Jr.
SPEAKER_00:Well, my book documents a lot of what he actually said. Trevor Burrus, Jr. Right. And he was he didn't mince words. He would be in front of the Senate Budget Committee and say, hey, this is your purview, and you've got to get the budget under control. Trevor Burrus, Jr.
SPEAKER_02:I have heard Chairman Powell say this of late. I've heard him in a couple of different press conferences allude to the fact that this is just one lever that we're pulling, but that Congress has also got to do, or in actually it wasn't a press conference, it was in his testimony before Congress. Do you think that they just pay lip service to it? Or do you think Congress isn't listening? Or are we the voters just miss not hearing that part?
SPEAKER_00:I think central bankers - this goes back to independence. I hear this all the time: that, well, we can't be outspoken about fiscal policy because that would threaten our independence. And so yeah, independence is this kind of slippery thing that you've got it until you use it, is the way they think about it. Or that's a little bit unfair. They want to save their ammunition for when it really matters. Trevor Burrus, Jr. I see. Well, if it doesn't really matter now, I don't know when it's going to. And my problem with a lot of what you hear from central bankers is it's almost gratuitous. It's fiscal policy is on an unstable, unsustainable long-run track. Well, duh, we've known that for decades. Trevor Burrus, Jr. Sure. So tell me something more.
SPEAKER_02:Trevor Burrus, Jr.: But then take me back to that question that I raised, which is by the Fed's significantly increasing rates, it really has fomented a fiscal crisis where the government, as you mentioned before, is presently closed because the parties can't agree on a budget. And the consensus seems to be that they're either going to have to figure out a way to raise taxes or cut spending or both. So doesn't that affect the same end?
SPEAKER_00:Well, if it happens, yes. But I think the politics now is very different than it was when Volcker was in office. And the other thing to remember about Volcker is he was raising interest rates when debt GDP was about 25 percent. Now it's 100 percent and growing. And so the circumstances just the physical uh sorry, the fiscal state is very different now than it was then. We also are seeing lots of little signs that um of problems with placing treasuries in the market. Uh we've had some weak auctions where uh they're called tailing auctions, and that means that um the the interest rate that had to be offered to get people to buy the bonds uh was higher than expected than people expected it would be. We have seen the Treasury move from issuing long bonds to short bonds because they've had trouble placing long bonds. In March 2020, there was what's called the dash to cash, um which if you read some of the financial representations of this, make it sound like it had something to do with all the microstructure that was going on in the treasury market. Uh if you read Daryl Duffy, who I think is uh probably the best thinker on this topic, the first thing he lists is well, the supply of bonds has been really high, higher than the Treasury market can absorb.
SPEAKER_02:Trevor Burrus Well, and there it's dynamic, isn't it? And you know, it if we lived in a world in which equity markets were in the doldrums, I imagine having a pretty big supply of treasuries might not be so problematic. But if if we're in a world in which there's mostly risk on, uh then I can see the world being like you describe it.
SPEAKER_00:Trevor Burrus Although I think there's another international dimension here to bring in, which is that um at at their peak, foreigners held over 50 percent of government debt. That was uh U.S.
SPEAKER_02:government debt.
SPEAKER_00:Yeah. Trevor Burrus, Jr. U.S. government debt. Uh and that was what what was that, maybe 2015 or something. It's now around 30 percent. And uh and what we've seen is that a lot of uh foreign central banks have gone into gold and out of treasuries. Um I don't see any reason to think that that trend is going to reverse. Uh so what I'm trying to say is there are there are lots of little signs, and we can explain away every single one of them with different stories.
SPEAKER_02:Yeah.
SPEAKER_00:But when you take them as a whole, what we see is that the situation now is very different than when when Volcker was chair. And I think that all of this is a is a sign that um bond markets are starting to think that, well, maybe we're not gonna get the fiscal reforms that we always have. So this is another point that I like to bring out. There's this thing I call the Hamilton norm, which goes back to Alexander Hamilton, who was the first Treasury Secretary, and his first statement to Congress uh in 1790 was uh laying out his vision of U.S. Treasury market. And he said, you know, we have to have a safe and sound uh public debt. And the way we do that is by making sure we pay our bills and we pay our bills promptly. Right. But he wanted to have a permanent amount of debt because he envisioned that a safe public debt could substitute for money. You look at how the U.S. Treasury market has evolved to what it is today, and you see, man, that guy Hamilton was smart. Trevor Burrus, Jr.: Yeah.
SPEAKER_02:I mean, it's pretty much I mean, in so many different corners of financial markets, treasuries I mean, at a bet at a base level, we describe treasuries as the risk-free asset. Trevor Burrus, Jr.
SPEAKER_00:Exactly. And so um so that that Hamilton norm, which I summarize as deficits beget surpluses, um doesn't seem to be the prevailing view on Capitol Hill these days. Uh the last time we had that notion uh communicated by an elected official was Obama, who five days after passage of his um his stimulus package, he pledged to reduce the deficit by one-half by the end of his first term. And if you look at the debt GDP ratio in the United States, which I've described as kind of this step function, one of those steps was Obama. It sort of debt flattened out, and then we got the Trump tax cuts, and that shot up, and then we got COVID and it shot up again. Trevor Burrus, Jr.
SPEAKER_02:Yeah. One of the things I so this morning ahead of our conversation, I uh I took a look at Fred, which for listeners who might not know is a creature of the St. Louis Federal Reserve Bank and is a really great place to find all kinds of data. Um I took a look at Fred because I was curious to see what the U.S. government's primary deficits have looked like historically. And what I observed is that we've been running primary deficits pretty commonly since at least 1970, um, but with the exception of 1998 to 2001. But there hasn't been any evidence. If we're following, if I'm following the thread of your logic correctly, what we should have been seeing from 1970 to the present is a persistent and difficult to include uh to control rate of inflation, but we haven't seen it. What do you think explains that?
SPEAKER_00:Aaron Ross Powell I think that they I really do believe that that faith in the Hamilton norm um is what holds everything together. Aaron Ross Powell Got it. And you know, uh it's a little bit just looking at the actual surplus uh data can be a bit misleading. And I say that because if I go back to the 1980s, um after Reagan's tax cut, which in it was in 81, by 82 there was a small increase in taxes. 83 there was a major reform to Social Security, which uh served to raise uh primary surpluses per uh permanently. Right. Then there was a sequence of other uh tax increases, including the famous uh George Bush, Read My Lips, No New Taxes.
SPEAKER_01:Right.
SPEAKER_00:Which he then reneged on. And then you had the Clinton very, very significant increase in both taxes and cutting spending. And so we had large primary surpluses.
SPEAKER_02:Trevor Burrus Interesting. So you think I mean the other thing that I think it's a great answer. I the other thing I noted is that what really struck me in just looking at a line chart of those primary surpluses and deficits. I think the data went back to the 1940s. Is that you can tell the story I just told, but sort of since 2008, it seems to have become untethered, right? That it's just like you could argue these different periods with different levels and so on. But beginning in 2008, prior to the 1980s, it seemed like on average, primary deficits were looking at anywhere from 0 to 2.5 percent from the 80s until 2007, around 5 percent, and it would pop around. But beginning in 2008, you were talking about primary deficits of, you know, 10 percent at- uh at different stages. So is the alarm bell that something there's been a regime change that something it's not just we how do I want to say this? We expect, I think, uh in the story that you're telling, that politicians are rarely going to have the temerity to exercise the kind of control that we want them to on the fiscal side of the House. Um but that maybe what's happened is a complete disconnection to even trying. Is that a reasonable way to think about this as a like since 2008 moment or being too myopic?
SPEAKER_00:Aaron Ross Powell I guess there are a couple of things I want to emphasize here that um my point about just looking at the primary surplus data can be misleading, is really a point about expectations. And so what happened in the 80s was, yeah, we didn't get to primary surpluses, but people saw that we were taking the actions that would get us there. Trevor Burrus, Jr. Oh, I see. And so that changed how people thought about things. I see.
SPEAKER_02:It's not the level so much as how what conclusions people draw about the future. Trevor Burrus, Jr.
SPEAKER_00:And what are what are elected officials saying about it? Trevor Burrus, I see. Trevor Burrus, Jr. You know, so I really believe that when Obama said, I'm gonna do this, and then he did something, yeah, he didn't actually get to surplus.
SPEAKER_01:Right.
SPEAKER_00:But you saw that there was a decline in the deficits right toward zero. Right. So I that's a really critical point. I see. And now the problem is we're not hearing any of that now. And in fact, we heard the opposite.
unknown:Right.
SPEAKER_00:During COVID, the message was all about we're gonna send you checks, and these checks are gifts. They're not loans to just tide you over loans that you're gonna have to repay with interest in higher taxes. These are gifts. I mean, the Trump put his name on the checks. You don't do that if you're sending an IOU.
SPEAKER_02:Trevor Burrus, Jr.: Of course, the great irony is that the government doesn't have enough tax revenue to write those checks. So of course it's an IOU. It's just not an IOU for the recipient. It's an IOU for the recipient's children and grandchildren. Trevor Burrus, Jr.
SPEAKER_00:Well, and I think as it turned out, it was an IOU for bondholders because the surprise inflation ended up basically extracting the revenue from them with lower uh realized returns.
SPEAKER_02:So in your in your work, you uh you sort of counsel for that the prudent course is to use both monetary and fiscal policy, that it's important to think about both. Um but you've also suggested that we live in a world today of what you've called fiscal dominance. Describe to listeners what you mean by that and what the cause for concerns might be.
SPEAKER_00:Fiscal dominance is uh it's it's a kind of funny idea because some people think of it as okay, that means fiscal policy is just completely unresponsive to government debt, and we're in a bad world forever. Aaron Ross Powell Okay. But I hope not. Trevor Burrus, Jr.: Fiscal dominance pops up in in funny ways. Uh Liz Truss is my favorite example. She was uh the U.K. Prime Minister. Uh her uh exchequer of the Exchequer of the whatever Chancellor of the Exchequer. That's the fancy term. Yeah. Uh he announced that there were going to be these tax cuts and there were going to be these spending increases, and they were all going to get financed through debt. And um UK bond market had a hissy fit uh and and the value of the pound fell dramatically.
SPEAKER_01:Right.
SPEAKER_00:And the Bank of England ended up intervening to try to prop up the treasury market. But the thing about that was it wasn't until she stepped down that markets really settled down. To me, that's fiscal dominance. That's that's something happens on the fiscal end. And by the way, in that case, it was all about expectations.
SPEAKER_02:Yeah.
SPEAKER_00:No spending has taken place. Right.
SPEAKER_02:Yeah, nothing at all.
SPEAKER_00:So it was all about expectations. And even though the Bank of England said, oh, we're going to do whatever we need to, uh, they also set a deadline on when they were going to stop. And uh and and markets, yeah, it sort of settled things down a little bit, but then they went back up again. And it wasn't until they cleaned house that everything settled down. So that's fiscal dominance when fiscal policy does something that um forces the central bank to be subservient. So the Bank of England had no intention of intervening. They were trying to shrink their balance sheet at the time. They stopped what they were doing to try to patch together a fix. And so more broadly, um, you can think about fiscal dominance as when the Hamilton norm doesn't hold. Right. That uh if if what's happening is the central bank raises interest rates, interest payments grow, if you just finance those by further borrowing, that's fiscal dominance. If nobody believes that taxes are really going to go up to pay off this stuff, then gosh, I'm a bondholder, I'm getting higher interest payments, I'm richer. Yeah. I want to go out and spend.
SPEAKER_02:Yeah. Right? Yeah. Pushing up inflation and working against what the Fed's goal would otherwise be.
SPEAKER_00:Trevor Burrus, Jr.: And then there's this feedback loop that, well, then the Fed says, oh gosh, inflation's going up again, we better raise interest rates again. Well, then debt starts to grow even more rapidly.
SPEAKER_01:Yeah.
SPEAKER_00:So that's fiscal dominance. And if you live in that world, if you live in a world where people are not confident that Congress is going to get its act together, then the Fed needs to have a plan B. It needs to recognize that it can no longer control inflation. And it's got to figure out what it can do. Because if it keeps trying to control inflation, it's going to make things explode.
SPEAKER_02:Trevor Burrus, Jr.: Well, if it keeps trying to control inflation in the way it has historically done it, so by raising rates. And you're let me see if I understand this. If the Fed keeps trying to control inflation, like presently, we've noticed that there's, again, another sort of modest uptick to U.S. inflation. And we're going to see numbers shortly, and we're going to see if that bears if it was a blip or if it bears itself out. If the Fed has to raise interest rates in order to do that, and the fiscal authorities aren't exercising any control or restraint, your story is telling us that that means they're going to have to borrow more, and by borrowing more, it's going to make bondholders richer, and bondholders being richer means they are going to spend more money, and spending more money is going to push prices up, and that means the Fed's got to raise rates again, and we get into a vicious cycle. So in that world, let's just take it as a given. I mean, I'm a I'm a little cynical about human nature, and I think it's probably asking too much of elected representatives to do the hard stuff. What does monetary policy have to look like?
SPEAKER_00:Well, it's not that monetary policy doesn't matter anymore. It is that what monetary policy can do is it can sort of decide exactly what the dynamics of the inflation will look like. It can raise interest rates and try to keep inflation down today, but then that will push the inflation into the future. Or it can just keep interest rates fixed and try to make the inflation as smooth as possible. Because the real distortion from inflation comes from it being very volatile and hard to predict. And so then the job of the central bank becomes more about okay, this world sucks. Let's make it suck a little less. It's a baseline question. Trevor Burrus, Jr. By allowing people to be able to predict inflation and then take account of that in their decision-making.
SPEAKER_02:Trevor Burrus, Jr.: Do you think there's much cause cause to imagine that in the same way you described happening in the U.K., that the U.S. bond market at some point comes to a conclusion and says these guys need to get their heads screwed on the right way, and causes the same sort of major problem in the bond market, forcing the fiscal authorities to act, whether they like it or not?
SPEAKER_00:Aaron Ross Powell Yeah. The thing about that world is that it's a very hard to predict these things. So I uh I opened my book by talking about Argentina in 1989 when uh in July the uh monthly let me emphasize monthly inflation rate was 200 percent.
SPEAKER_02:Yikes.
SPEAKER_00:Um and I went through a description of kind of what the monetary fiscal configuration looked like back then in Argentina, and I saw some striking parallels with the United States today. Now, the thing about hyperinflation is it comes on fast. Uh you know, it's not that they had 2 percent and then it became 1,000 percent, but um but if you look at the data, it went from maybe five, seven percent monthly, which is still pretty high by our standards to 200 percent.
SPEAKER_01:Yeah.
SPEAKER_00:And um and so you can get a run on the Treasury market. Uh nobody wants that. And I think everyone, you know, the Fed is going to do everything it can to avoid that. But um these things can happen very quickly and very unpredictably. And uh the sensible thing to do is never get to that point. Yeah. Not dance around it and say, hey, it hasn't happened yet. Aaron Ross Powell, Yeah.
SPEAKER_02:But I mean, one I wonder, maybe I'm just being an optimist, but I wonder whether the given the size and the depth of the U.S. Treasury market, I wonder if that's compared to, say, the market for Brazilian government - I mean, uh Argentine government debt is I wonder whether it's not a market that's less likely to wait for the Argentina facts to happen and will have a tantrum and push the fiscal authorities to act.
SPEAKER_00:Well, see, this is this is where seeing beyond the monetary narrative is so important.
SPEAKER_01:Yeah.
SPEAKER_00:Because part of that monetary narrative is that, well, gosh, if there's some financial instability that has to do with regulations about dealers or something, well, let's deal with that. Let's not actually ask ourselves why this is happening. We'll just analyze the minutiae and and then we can change regulations, the Fed can step in and do some interventions and try to smooth things over. Right. And so I you know, I think the bigger the bigger question here, and this is really what in my dreams would be the impact of my book, is if you start to embrace the fiscal foundations of inflation, then Congress has to own it. They have to we have to hold them responsible. And as long as we live in this fantasy world that, oh well, the Fed the Fed is what inflation is all about. The Fed can always get it under control. Yeah, they may have to make trade-offs to do it, but there's never any doubt that they can do it. Um if we're in that world, then Congress is off scot-free.
SPEAKER_02:Well, there's my cynical point from earlier is wondering whether that wasn't a mindful choice.
SPEAKER_00:Aaron Powell Well, you know what's so strange about this is if you look at the uh presidential election, inflation supposedly was a big factor. Yeah. Um and if you look at certain kinds of uh surveys, Americans uh believe that fiscal policy, government debt, deficits, et cetera, is a driving force uh uh behind inflation.
SPEAKER_02:Aaron Powell So this disconnect is not the people. This disconnect is among the elites who are running the show.
SPEAKER_00:Trevor Burrus It's not just those, it's also the reporters, um, it's the textbooks, it's you know um and and I think it's be you know, if you go go back to the 70s, sixties, fifties, Paul Volcker even, you know, he just had a gut feeling. He didn't have a formal theory for this. He just had a gut feeling that when the government pumps too many bonds into the economy, it's gonna cause inflation. And I don't know why we got rid of that feeling, except I blame Milton Friedman.
SPEAKER_02:Aaron Ross Powell, yeah. Well, he put a he put a period at the end of that sentence, didn't he? Aaron Powell This has been super interesting. I like to end the podcast by asking you a curveball. And so here's the curveball. Share with listeners a pearl of wisdom. It can be on this topic, it can be personal, it can be about anything you find interesting, but just something that you'd like to leave everybody with.
SPEAKER_00:It's one of my favorite quotations. Time flies like an arrow. Fruit flies like a banana.
SPEAKER_02:Terrific. Eric Leaper, thank you. This has been most interesting. I really appreciate it.
SPEAKER_00:It's fun. Thanks.
SPEAKER_02:You've been listening to Not Another Investment Podcast, hosted by me, Edward Finlay. You can find research links and charts at Not Another Investment Podcast.com. And don't forget to follow us on your favorite platform and leave comments. Thanks for listening.
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