In ation, Monetary and Fiscal Policy, and Japan
John H Cochrane1
1. A perfect monetary policy outcome
The standard narrative for Japan says that an asset price “bubble” burst, nancial turmoil
brought down the economy, the Bank of Japan lowered interest rates but got stuck at zero. A“liquidity trap” or “de ation trap” then set in, and despite valiant e orts of scal stimulus,
unconventional monetary policy (QE, forward guidance, negative rates, long term bond pricesetting), Japan remained mired in secular stagnation for 30 years. Only with the arrival of thecovid “supply shock” did in ation unanchor from the perverse no-price-change psychologythat had set in, nally allowing Japan to return to a healthier 2% in ation which will at last allow
a return to growth. (For an eloquent exposition, see Shinichi 2024.)
I o er—really remind us, as the observation is not new—an alternative narrative. In thisnarrative, the BoJ and monetary a airs is not to blame for 30 years of lost growth, which may
be good news. But the BoJ is also much less powerful to be the engine of revitalized Japanese
growth, which is not always welcome news to a central bank.

1 Hoover Institution, Stanford University; NBER, Cato, SIEPR, Stanford GSB.

Johnhcochrane.com; john.cochrane@stanford.edu. Paper prepared for the 2024 BOJ-IMES
Conference, “Price Dynamics and Monetary Policy Challenges-- Lessons Learned and Going
Forward” May 27-28, 2024; Institute for Monetary and Economic Studies, Bank of Japan.
https://www.imes.boj.or.jp/en/2024MayR6/conf2024.html This essay includes, without speci creference, many ideas in Cochrane (2023) (2024a) (2024b).

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I start with a radical claim. Japan has, for 30 years since the mid 1990s, had the most perfectmonetary policy outcomes the world has ever seen.
Not only has there been no in ation, the price level has been steady. When the US Congress orthe EU commission said unto the Fed and the ECB, “price stability,” this is likely what they had
in mind, not 2% in ation, with the price level forgetting past mistakes.
Interest rates have been zero, as Milton Friedman’s optimal quantity of money recommends. At
zero interest rates, people waste no time economizing on cash. More importantly, nancial
institutions do the same. There is no incentive to create run-prone interest-bearing money suchas overnight repurchase agreements.

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car. It’s optimal to drive the car full of oil, if you can do it without causing in ation. Japan has
done so.
A steady price level was not the announced policy of the Bank of Japan, nor the desire of themany American economists who came before me to criticize it. But, as the great Mick Jagger
once proclaimed, “you cant always get what you want. But if you try sometimes, you just mightnd, you get what you need.” The outcome has been nearly perfect even if that was noto cially intended.
What of the supposed 30 years of stagnation supposedly brought on by the de ationarypressure of the zero bound? On basic principles, monetary non-neutrality doesn’t last 30 years.
If there is a 30 year growth problem, it’s a growth problem, microeconomic notmacroeconomic. The recent in ationary episode in the US shows that sticky price nominal-realinteractions happen on the time scale of a year or two, not thirty. There is no sign of perpetuallack of demand. Japan’s unemployment rate has been below that of the US the entire time.

Yes, Japan’s GDP growth has slowed, showing less growth than the US. But Japan’s GDP per
working age person has grown faster than in the US. (Shirakawa 2023; Fernández-Villaverde,
Ventura, and Yao, 2024.) Japan’s total GDP is growing slowly simply because its population is
declining. Perhaps Milton Friedman (1968) should have extended his list of things thatmonetary policy cannot do. Monetary policy cannot create or retard long-run growth. And
monetary policy certainly cannot induce people to have babies!

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Japan is satiated in liquidity. The BOJ balance sheet is over 100% of GDP. Money is oil in the

4I do not mean to say all Japanese economic policy is perfect. After WWII Japan had a rapid
period of catch-up growth. That hit an in ection point in 1973. Japan’s per-capita GDP cameclosest to the US in 1991, peaking 16% below the US. On either per capita or per working age
person basis, Japan got stuck substantially below the US level of output per worker, andremains in the general territory of Italy. (I use GDP per capita here and below because I don’t
have easy access to the GDP per working age person data.) Japan’s productivity growth has
been slower than the US (which itself has slowed down). But productivity growth is not a lackof demand problem.
With a well-educated, industrious, and thrifty population, homogenous society, the lack of
pockets of isolated poverty and dysfunction, and general cleanliness, safety, and order thatstupefy American tourists, Japan should have passed the US, as Singapore has. Still, Japan is
29th on the World Bank’s ease of doing business index, well behind the US 6. The easiest way
for Japan to lower its debt to GDP ratio is to raise its GDP. And that takes microeconomic
reform, not macroeconomic machination.
Growth Economics is clear: Each country catches up to the productivity frontier, until its level ofmicroeconomic ine ciency stops it. That too, however, is something monetary policy can do
nothing about.

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The end of catch-up growth suggests an answer to another common complaint about Japan,that it had a “bubble” and 30 year slump as a result. The transition from “catch up” to “frontier- level ine ciency” growth can cause prices to crash, not necessarily the other way around.
Suppose a country starts with 1/5 of the US GDP per capita. It enters a period of “catch-up”
growth, adopting successful “frontier” institutions and rapidly investing. Eventually, however,“catch-up” growth must end. The formerly poor country reaches the technological frontier,minus whatever “level” e ect its microeconomic ine ciencies allow it. After that, it grows onlyat the “frontier” growth rate.
It might get stuck in the “middle income trap,” like Brazil, 75% below US GDP per capita. It
might continue, as Germany and Western Europe did, reaching 20% below US levels before
plateauing. It might reach the US level. The US hardly has perfect microeconomic institutions,and I estimate it’s easily possible to reach 40% or more above US levels by adopting freemarket growth-oriented policies. Singapore hints at that possibility, rising 20% above the US. (Ileave out the darker possibilities, of then sinking into zero growth sclerosis like Italy, ordisasters like Venezuela and North Korea.)en
While the country keeps growing at high “catch-up” rates, everyone (except the usual chorusof doomsaying US commentators) knows the fast growth will stop at some point, but nobody
knows for sure when. Asset prices re ect the possibility that growth keeps going. When the
country hits its microeconomic barrier, and starts growing at the frontier rate, asset prices nolonger include the option for greater growth, and collapse.

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rate be gh, and think of the price of a consumption claim. The price-consumption ratio in the
low-growth state is pcl = 1/(r − gl ), where r is the expected return, the same for all
countries. While the country is growing quickly, each year there is a probability λ that growth
will revert to the frontier growth rate. I work out in the appendix that the price-consumption
ratio while the country is growing quickly at gh isr − gl + λpch=.
pcl ( r − gh + λ )For example, with r = 4 % , gh = 8 % , gl = 2 % and λ = 5 % (20 years of growth on
average), we have

pch
4−2+5
=
= 7.
pcl ( 4 − 8 + 5 )Stock prices with high growth are 7 times higher than with low growth. When the economy
nds its limit and starts growing at the frontier rate, the stock price falls to one seventh its
original value! With a smaller 6% per year catch-up growth rate,

pch
4−2+5
=
= 7/3 = 2.3
pcl ( 4 − 6 + 5 )The stock market still falls in half.
In sum, I o er a plausible counter-narrative, based on simple growth theory rather thancomplex Keynesian macro. Japan switched from catch-up growth to frontier growth, at a levelre ecting microeconomic ine ciencies typical of Europe. Asset prices fell. Interest rates hit
zero and the in ation rate stopped. The BoJ was handed a golden opportunity, which it took.
The zero interest, steady price level monetary Nirvana is hard to get to. To get there directly, acentral bank has to wait out adverse temporary dynamics. Alan Greenspan talked about
getting to the zero in ation ideal opportunistically in this way. Japan then lived 30 years of
optimal monetary policy outcomes. And the real economy continued to follow real, “supply”
driven forces, as it must in the long run.
2 This story is not original. I heard it in casual conversation, but I don’t remember who I was

talking to or what paper they were citing. If anyone knows the correct citation, please write.

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To make this story concrete,2 let the frontier growth rate be gl and the high catch-up growth

Source: Kakuho, Hogen, Otaka, and Sudo (2024).
As I learned at the conference (Kakuho, Hogen, Otaka, and Sudo 2024), Japan developed a“no price change norm,” in which most businesses do not change prices and customers
expect no price changes. Most of the conference discussion thought this a terrible thing, andcelebrated the return of in ation to break that norm.
This too may be regretted. We all wish expectations to be “anchored.” Zero is a much clearer
anchor than 2%. If I say “in ation is 2%, I’m raising prices 2%,” my customers will react, “well,your supplier’s in ation, your city’s in ation, your wage in ation is less than 2%, in ation is
mismeasured, what about core/supercore/ex housing, etc.; you’re trying to take my money.”
Zero is zero.
The expectation of no price level change is much stronger than an expectation that in ation will
somehow get back to 2% by central bank resoluteness, It applies to individual goods, not justthe average.

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So, a steady price level and a widespread zero price change norm for individual goods is muchstronger anchoring than an in ation target. If Japan manages to join the rest of the world at a
hoped-for 2%, the BoJ may well regret nally getting what it wants rather than what it needs!
2. In ation and Fiscal Theory
My main task is to apply scal theory of the price level. I'll start by explaining how it neatly
describes US experience, and then consider how Japan might t as well.3
The scal theory of the price level states simply that prices adjust so that the real value of debt
equals the present value of primary surpluses.

∞ s
Bt−1
t+j
= Et
∑
Pt
R
j=0 t,t+j

or, linearized,

vt = Et∞∑
j=0ρ j(s̃t+1+j − rt+1+j )Where B is debt, P is price level, R is real return, s is real primary surplus, v is the log real valueof debt, ρ is a constant of linearization a bit below one, s̃ is the surplus scaled by the steadystate real value of debt, and r is the log return.
It’s just asset pricing applied to the government. In ation results when there is more debt thanpeople think the government can or will repay by a long stream of primary surpluses, lessinterest costs.
The asset pricing analogy quickly dissipates common criticisms. No, surpluses need not be“exogenous,” anymore than coupons and dividends are “exogenous.” No, this is not an“intertemporal budget constraint,” any more than Tesla must by budget constraint raise
dividends if a bubble sends up its stock price.

3 I draw here on The Fiscal Theory of the Price Level, “Expectations and the Neutrality ofInterest Rates,” “Fiscal Narratives for US in ation,” and “Fiscal Histories,” all on my website.

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de cits and in ation. Normal, responsible scal policy consists of borrowing in bad times,
followed by repayment in good times, with no change to the present value of surpluses. We
expect to see governments frequently run big debts and de cits with no in ation at all.

In ation only comes when people believe part of an addition to debt will not be repaid. They try
to get rid of nominal debt. The only way to do so is to try to buy goods and services until the
price level rises to in ate away su cient debt.

In ation can come, seemingly out of nowhere, as it often does, with no debt or de cit, if people
lose faith in the government.
I do not envision that people sit around the kitchen table making forecasts of government
nances 30 years in the future. In ation results from debt without faith in the fundamental
soundness of institutions, that the government will get around to paying o debt sooner orlater.

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As you can quickly see, scal theory does not imply a mechanical relationship between debt orThere is no magic debt / GDP ratio past which debt is “unsustainable” and in ation breaks out.
Countries that can pledge responsible structural scal policies can borrow a lot, and pay it oover decades. Countries that cannot have experienced debt crises with very little debt/GDP.
The present value also highlights that discount rates, equivalently interest costs on the debt
matter. The linearized version of the present value formula makes this implication stark. Interest
costs enter symmetrically with surpluses. One percentage point of interest costs is the same as
one percentage point of de cit to debt ratio. (We can also view debt as an undercounted
present value of the total surplus, including interest costs.)
The analogy to asset pricing should also help us to avoid repeating 50 years of hard-won
understanding. You cannot prove that price is not the present value of dividends by noticingthat Tesla’s price is a lot higher than forecasts of its earnings would seem to justify. Absent
arbitrage there exists a discount factor such that, etc., and agents have more information than
we do. You cannot prove that debt is not the present value of surpluses just by noticing thatJapan’s debt to GDP ratio is pretty high.
Now, consider what happens when the government suddenly gives people $5 trillion dollars ofmoney or debt, 30 percent of outstanding debt, but only has credible plans to pay back about
half that amount. I call that decline in present value of surpluses a “ scal shock.” In this simple
slide the theory predicts that prices jump up 15%.
But we know prices are sticky. So let’s turn to scal theory with sticky prices. I just add scal
theory to a totally standard new-Keynesian model. I give the model a scal shock, andsuppose the central bank leaves interest rates alone.
(The model is, in standard notation,

xt = Et xt+1 − σ (it − Et πt+1)
πt = βEt πt+1 + κ xt
ρvt+1 = vt + it − πt+1 − s̃t+1
0 = lim Et ρ T vT
T→∞

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The plot is the response to a 1% decline in surplus.)

Rather than a sudden price level jump, we get a slow price level rise. In ation jumps up, thenslowly declines. Bondholders lose money from a long period of low real rates, interest rates
below in ation, rather than from an overnight price-level jump.
In reality, in ation often builds slowly rather than jump upward. In most events, there areseveral shocks. The extent of the scal shock only became known slowly through time. We
also measure in ation year over year, as shown in the dashed line, which gives an apparent
slow rise in in ation. And of course this is a very simpli ed model, without habits, capital, andadjustment costs, all of which draw out responses.
In ation goes away all on its own here, with no high interest rates and no recession. There wasa one time scal shock. Once su cient debt has been in ated away, there is no need for morein ation.
Next, what if the central bank wakes up and raises interest rates? I present the results of sucha monetary policy shock. (This model includes long-term debt.) Crucially, here I do not assume
any contemporaneous scal shock. Surpluses stay constant. This is what the central bank can
do on its own. Almost all current models pair a scal tightening, some of the last graph upside
down, with a monetary tightening. They assume at a minimum that scal authorities raise taxes
to pay extra interest costs on the debt. I ask here what central banks can do on their own
without such help, which may not be forthcoming.

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Higher interest rates lower in ation and output. However, they raise in ation in the long run. A
form of “unpleasant arithmetic” holds here, and quite generally.4 The central bank can only
move in ation around over time. This is a pretty normal-looking plot. Nobody would notice theslight long-run rise as something else would have happened by then. But the mechanism isutterly di erent from standard central bank doctrine, that higher rates depress aggregate
demand and through a Phillips curve depress in ation.
In the scal theory model, it is a great and good thing for the central bank to react to in ation inthis way. By raising interest rates in response to the scal shock, the central bank smooths theinevitable in ation over time. Since output depends on in ation relative to future in ation, thatsmoothing reduces output volatility. A Taylor rule, with a coe cient just below one, is a very
robust policy. The Taylor rule seems to always be the answer, even as the questions change. It
brings stability to old-Keynesian models, determinacy to new-Keynesian models, and low
volatility to scal theory models.

4 For the general point, including old-Keynesian adaptive expectations models, see“Expectations and the Neutrality of Interest Rates.”

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government did indeed send people $5 trillion of money with no clear plans to pay it back.
In ation promptly surged, seemingly out of nowhere, just like the simulation.
Conventional theory says that once in ation is 8 percentage points above interest rates,
in ation will spiral upward until interest rates substantially exceed in ation, and drive it backdown with a 1980s style recession. Fiscal theory says in ation would go away on its own,
absent new scal shocks. In ation goes away a bit faster if central banks react, though a thecost of a slightly more persistent in ation. That also seems to be just where we are.
It’s not that easy of course. Why this time and not 2008? One has to do a historical analysis tobelieve that it is at least plausible that this time people did not expect about half that debt to be
repaid by surpluses or lower interest costs, and last time they did. My papers include thatnarrative, but in the interests of time I won’t repeat it here. This narrative is not proof, but thatscal theory has even a plausible story, one so simple, and one that gets the quantities right for
both the rise and fall of in ation, is pretty novel.
This in ation surge has huge implications for economics and economic policy, which have notbeen digested yet. For 13 years in the US and EU and 30 in Japan the policy consensus
focused on “inadequate demand,” “secular stagnation,” the idea that we just needed morestimulus to get the economy moving. Borrow or print a few trillion dollars of money, they said,
spread it around and prosperity will follow. In the same period, with ultra-low interest rates,
large de cits, and low in ation, “r<g”, Modern Monetary Theory and other doctrines spreadproclaiming that government debt is a free lunch, never needing to be repaid. MMT preachedthat “there is always slack” in the US economy, so one never need worry about stimulus
causing in ation. Borrow or print a few trillion dollars of money, they said, and don’t worry
about paying it back.
Well, in 2021 we did exactly what this consensus asked. And we got in ation. That is an
important lesson. There was genuine uncertainty about what would happen, in the 2010s, if amassive scal-monetary stimulus were attempted. Now we know. “Damand” bashed in to thebrick wall of supply, and surprisingly soon. If you want more economic growth now, there is noalternative but incentives and microeconomic e ciency; growth. If you want to borrow and do
not wish to cause in ation, you must have a plan for paying it back. Economics is back to

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Having seen these graphs, you know how I’m going to interpret recent US history. Ourinterrupts such pleasant dreams. It seems like Tokyo is more awake.

I leave out here “supply shocks,” and the less serious greed, price-gouging, monopoly, andshrik ation excuses for in ation, as I do not see that we need them. Supply shocks in particular
are fundamentally shocks to relative prices, not to the price level. To generate in ation rather
than a transitory spike in relative prices, monetary or scal policy must accommodate supply
shocks with more demand. New-Keynesian models with supply shocks do that with both larger
money supply and larger “passive” scal policy changes. (This is true, for example, of Balke
and Zarazaga 2024 and Smets and Wouters 2024, who estimate new-Keynesian models withscal theory and estimate substantial “supply shock” e ects on in ation.) Then the supply
shock really is just the occasion for a monetary- scal expansion, the carrot in front of themonetary- scal horse that pulls the in ation cart. The same supply shock with noaccommodation has no in ationary e ect. Why then call it a “supply shock” rather than a“supply induced demand shock,” which it is? We might as well call it a “covid shock,” as theoriginal shock was the pandemic, not to supplies. OK, covid led to behavior and policies thatshut down the economy, the government responded with huge scal stimulus, and we got
in ation. Is that a “covid shock” that causes in ation? No. Covid induces scal and monetary
policies that cause in ation.

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normal. Washington has not woken up to this slap-in-the-face lesson, perhaps because it3. Japan vs. US in ation
Japan has had less in ation than the US in this episode. Given Japan’s famous debt to GDP
ratio, how can that be?

First, it’s not obvious that Japan really has had lower in ation than the US. Japan’s in ation
started later, but also peaked later. The unexpected rise of in ation, and hence what fraction ofdebt was in ated away is actually about the same. But di erent measures di er, and we can atleast ask why Japan’s in ation was not much worse.
In the simplest case, exible prices and short-term debt, scal theory states∞
Bt= Et+1
β js.
∑ t+1+jPt+1
j=0

Taking innovations and rearranging,∞
Bt
Pt(Et+1 − Et )= (Et+1 − Et )β j st+1+j∑Pt( Pt+1 )j=0∞
st+1+jPt(Et+1 − Et )= (Et+1 − Et )βj.
∑ ( Bt /Pt )( Pt+1 )
j=0

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Unexpected in ation is equal to the change in expected surpluses divided by initial debt. With
sticky prices and long-term debt, this describes the overall price level increase in the episode.
So, why might a country have less in ation than another?
• First, obviously, a country might have less de cit, the initial series of negative st+j.
• Second, a country might promise to repay more of that de cit; the same initial negative st+j
might be paired with greater subsequent positive st+j. When we expand the model to include
time varying interest costs (important!), subsequently lower interest costs have the samee ect as higher subsequent surpluses.
• Third, and most importantly, more debt B /P means the same stream of de cits andsurpluses {st+j} generates less in ation.
Read that again. Yes, more debt means that de cits have less in ationary e ect. At 100% debt
to GDP, 1% in ation in ates away 1% of GDP debt and pays for a 1% of GDP unfundedde cit. At 200% debt to GDP, 1% in ation in ates away 2% of GDP debt, and pays for 2% of
GDP unfunded de cit; equivalently, 0.5% in ation in ates away the same 1% of GDP unfundedde cit. A $1000 loss lowers Tesla’s stock price by 1/557,160,000. It lowers the value of a
$2,000 food truck business by 50%.
Your intuition that more debt must be dangerous for in ation re ects the correct intuition that
more debt relative to GDP means that the government is closer to its scal limits, so thatraising surpluses might be a lot harder. Countries with lower debt and more scal space nd it
easier to promise surpluses to fund a given de cit. But for a given path of surpluses, more debt
means less in ation.

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So, why did Japan have less in ation (if it did)? Well, rst of all, Japan ran de cits about half
the size of the US in the pandemic.

Second, looking across countries, Barro and Bianchi (2024) nd that covid-era in ation lines up
beautifully with de cits scaled by the value of debt. Barro and Bianchi also correct for duration.
Longer duration like stickier prices allows a given surplus shock to be re ected in in ation that
occurs after the 2020-2022 window. Japan lies comfortably on the line linking the othercountries.
That all countries lie on a line with a slope of about half means that all countries are expected
to repay about half of their covid de cits. Variation in that fraction is one source of variation ofcountries about the line.

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In sum, reading Barro and Bianchi, Japan had less in ation in 2020-2022 because it did lesscovid spending, because it had much longer-term debt than other countries allowing 2023 andfurther on in ation to devalue some of its debt, because it has a lot more debt in the rst place,and, slightly (deviation from the line) because Japan is expected to pay back a slightly larger
fraction of its covid era spending.
4. Japan provided crucial experiments
Japan’s 30 years at the zero bound, with huge QE, also provided the world with a crucial
experiment that decisively lets us distinguish theories of in ation.
The most classic theory of in ation under an interest rate target, unifying Milton Friedman(1968), ISLM adaptive or “anchored” expectations models, and the verbal doctrines espoused

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uniformly by central banks, policy institutions and commentators (though unpublishable in any
contemporary academic journal) states that in ation is unstable under an interest rate peg. The
central bank must swiftly move interest rates in response to in ation, like a seal balancing a ballon its nose, to keep in ation from spiraling away. If the bank fails to do that, as alleged of the
1970s, or if the bank is constrained from such movement, as occurs at the zero bound, an
in ation or de ation “spiral” will develop. At the zero bound, a small de ation means a high realinterest rate, that lowers aggregate demand, lowers output, creates more de ation, and around
we go without limit.

When Japan hit the zero bound in 1994, and when the US and Europe did so in 2008, thecentral bank and policy community widely and correctly, given the logic of this theory of
in ation, warned of a spiral to come and urged heroic e orts to avoid it.
New-Keynesian theory developed since the early 1990s uses rational expectations. Thesemodels are universal in the equations of central bank and academic research, though notalways in the words describing those equations. These models use rational expectations. They
predict that in ation is stable at a peg or zero bound, but indeterminate. There can be multiple

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equilibria, and excess volatility as the economy bats uncontrollably between multiple equilibria.
This is not a small technical issue. Given that in ation is stable, multiple equilibrium volatility is
the central new-Keynesian complaint of 1970s monetary policy. In this theory, the Taylor rule
worked in the 1980s by eliminating multiple equilibria (Clarida, Gali and Gertler 1999, 2000).
New Keynesians warned loudly, and correctly given the model, that any return to the zerobound would lead to more such volatility (Benhabib Schmitt-Grohé and Uribe 2001, 2002).
Adding scal theory to new-Keynesian rational expectations models, we at last obtain a theoryof in ation under interest rate targets that is consistent with current institutions (interest rate
targets rather than money supply control, central banks do not make explosive o -equilibrium
threats). It says in ation is both stable and determinate under an interest rate peg. In ation
surprises come from scal surprises, so in ation will also be quiet (the opposite of volatile) if
there is no bad scal news — if people expect de cits to be repaid eventually.
This stability and quiet works much like an exchange rate peg. We all understand how an
exchange rate peg can nail down the exchange rate and relative price levels, if a government isfully committed to the peg and always provides the necessary scal resources to back the peg.
Pegs unravel when they do not have that scal backing. The proposition of stability at aninterest rate peg requires the same backing. Most observed interest rate pegs until 1994, andespecially those referenced by Friedman (1968), did not have that backing. Indeed,
governments imposed interest rate pegs as a suite of nancial-repression measures intended
to lower interest costs of a stressful scal situation.
Until 1994, we genuinely did not know the answer to this central question. What happens at aninterest rate peg or zero bound, not undertaken to paper over scal problems or in the depths
of a Great Depression? Given existing economic theory and experience, worries were justi ed.
Japan ran the experiment. It stayed at the zero bound for 30 years. In ation just batted within apercent or two of the zero bound, perhaps the quietest price level the world has ever seen. No
spirals, no multiple equilibria. Those theories are simply wrong.
Fiscal theory adds insight. A “de ation spiral” raises the payo s to bondholders, or
equivalently lowers nominal tax revenues but not nominal payments due to bondholders. The
government must respond to de ation with scal austerity, higher taxes and lower spending, to
pay this windfall to bondholders. In de ation spiral models, the government does so, thoughusually only in the footnotes that mumble something about lump-sum taxes. But nobody

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expects our governments to respond to de ation with austerity. Governments respond withstimulus, and helicopter money, with a string of negative primary surpluses. Given that
expectation, de ation can’t happen.

This experiment is crucial for the great question of monetary policy: Why do central banks havea 2% in ation target, not zero, and not a price level target? The main reason, as of 1992, wasfear of a tipping point, that the zero bound represented a dangerous entry to a “de ation
spiral,” a repeat of the great depression “liquidity trap” and so forth. Japan’s experience provesthat this fear, valid as of 1992, is unfounded. Zero in ation is possible and does not lead tode ation spirals. Fear not.
(The second reason is the idea that 2% in ation allows greater stimulus by lowering nominal
rates in recessions, a version of the theory that wearing too-small shoes during the day makes
it feel so good to take them o at night. I also disagree with this analysis, but that’s beside thepoint today of what we can learn from Japan.)Now, the asterisk is crucial. A peg or zero bound is stable and quiet if there is no bad scal
news, if people think de cits will be repaid. The proposition is only that a peg or zero boundcan be stable and quiet, if these scal preconditions hold.
Japan is also the classic case of ine ective scal stimulus.—Even immense scal stimulus
does not cause a boom in aggregate demand (I would add, with Ricardian expectations, that

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growth — and a huge debt to GDP.

Doesn’t the large expansion stretch the scal preconditions? Yes, but stretch, not violate.
Remember, what matters in scal theory is debt relative to expected repayment, and low
interest costs count in that expectation as well.
Many of my compatriots who ew here with a de ation spiral mindset, and advocating evenmore scal stimulus, impolitely pointed out that Japan never fully committed to the idea that it
would not repay debt, a commitment needed to create stimulus and in ation. To create in ation
you must threaten unsustainable debt. As soon as sustainability looked to be an issue, there
goes Japan raising consumption and other taxes again! It is very hard to shake a reputation for
long-term sober scal policy, especially if you don’t really want to do it. That criticism, together
with a global era of very low real interest rates, explains why these big de cits did not cause
in ation.
I take a di erent lesson: Japan’s 30 years of massive de cits, combined with a thrifty
reputation for responsible repayment, show that Ricardian equivalence really does hold, thatow de cits have no e ect if people expect repayment, that Keynesian scal stimulus ispointless.

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the new debt would be repaid). Large amounts of infrastructure spending did not lead to strong

I emphasize: scal theory says you get in ation if debt exceeds faith in a country’s long run
ability and will to repay. There is no hard and fast debt/GDP limit. Argentina has debt crises at
40% debt to GDP. Japan lasted a decade at over 200%.

M V = PY vs

B+M
=E
β js
∑ t+j
P

Japan also o ers us an immense and decisive experiment to distinguish scal theory from themost classic theory of in ation, monetarism. One can also object in theory, that monetarism
requires central banks to control the money supply. If they target interest rates, monetarism
predicts an unstable price level. But we have an even simpler and dramatic test before us.
Monetarism and scal theory agree that if the government drops $5 trillion of cash on people,
and they have no expectation of future taxes to soak up this money, you get in ation. That’s arise in the money supply but also a scal transfer, an unfunded de cit. The question is, what
happens if the government gives people $5 trillion of cash, but takes away $5 trillion of treasury
debt? Monetarism says that this gives the exact same in ation in both cases, as only themoney supply matters. Fiscal theory says, to rst order, there is no e ect on in ation. (I hedge
with “to rst order” as if money pays less interest than bonds there is a small seignorage e ect,and QE also shortens the maturity structure of debt.)

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Would someone please run the experiment? The US just did: First, about $4 trillion in QE which
had no e ect at all on in ation, and then $5 trillion covid spending, about $3 trillion of whichmonetized, which promptly produced about 15% cumulative in ation.
This is notable, because of the immense size of the experiment. Reserves used to be $10-$50
billion. $4 trillion is a bomb, not a recracker. It should have set o Zimbabwean levels ofin ation, and here we are arguing about 10 basis points of announcement e ects in long term
bond prices.

Was that not enough? Japan o ers an even larger experiment. The BOJ’s monetization is close
to 100% of GDP, where even the Fed can only get to about 25%.
These are as decisive experiments as we get in economics. We often fret about subtle
econometric tests, with little correlations and argue whether t or F statistics on an impulse
response function are signi cant. We argue about identifying assumptions and model
speci cations. Stability, determinacy, and the e ect of QE vs covid spending are massive
simple tests of the basic robust doctrines of each theory, not remediable by small changes.
Thank you Japan!
The combination of a zero bound, complete satiation in liquidity via an immense balance sheet,
and a completely stable in ation for 30 years unseat the central tenets of standard doctrine
spanning Friedman and ISLM policy analysis. It is possible to live the Friedman optimalquantity of money. Pretty much nobody thought this was true before Japan did it. Per ISLM
analysis, In ation or de ation spirals would break out. Per monetarism, the immense quantity

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of money would cause hyperin ation. Though Friedman described the “optimal quantity ofmoney” as a zero interest rate and satiation in money, he never advocated a peg at zero,preferring instead a k% money growth rule with low and posit
5. Fiscal Limits on Monetary Policy, Debt Sustainability and Future In ation
Large debts, and poor plans for repaying them, also are a constraint on monetary policy. In thelast great disin ation in the US, 1980, the debt/GDP ratio was 25%. It is now 100%. All ofthese in uences are four times larger — and the scal limits on monetary policy were alreadyevident in that episode.
This is a rst-order e ect. In the US, with 100% debt to GDP, each 1 percentage point rise in
the real rate is 1 percentage point rise in interest costs, which raises the de cit 1 percent of
GDP. That’s a lot. In Japan, with 250% debt to GDP, the same 1 percentage point rise ininterest rate costs 2.5% of GDP more de cit!
Higher interest rates have knock-on scal e ects. US bank regulators let banks load up on
long-term bonds while the Fed was preparing to raise rates. When rates go up, banks go
down. Monetary authorities may fear raising rates as a result. This “ nancial dominance” isalso basically a scal e ect, since bank failures will occasion scal bailouts, which have tocome from the same empty pot.
Higher interest rates cause recessions, which cause more stimulus, bailouts, and social
programs. This is not an unintended consequence. In standard macro, it is the essential
mechanism by which higher rates cool in ation; it is a feature not a bug. Higher rates lower
demand, that lowers output, and via the Phillips curve that lowers in ation, all with “long andvariable lags.” But it also is another scal impact of monetary policy.
In contemporary macroeconomic (not scal theory!) models, scal policy automatically tightens
to pay these costs. If scal policy does not or cannot tighten, interest rates lose their power tolower in ation. If another bout of in ation comes, as the last one did, from scal policy, higher
interest rates will just be gas on the scal re. Central banks in scally constrained economies
may turn out to be a lot less powerful than we think.
These limitations may already be playing out. The Bank of Japan has not raised interest rates
anything like as much as the US Fed has done. The yen has lost a third of its value. Is the BoJ

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nervous about the scal and nancial consequences of raising interest rates? The ECB owns alot of Italian (160% debt to GDP) and other sovereign debts. If it raises interest rates, thosecountries may again be in trouble. The ECB is now directly involved as it owns so muchsovereign debt, and is committed to buying more to keep sovereign spreads low. If in ation
rises again, will it be able to raise rates, and will doing so lower in ation? The US Fed mustcertainly be aware of the $1 trillion in interest costs that the Treasury is now paying, and its own
large mark-to-market losses which mean less money owing back to the Treasury, to say
nothing of the large number of banks in a similar position without the ability to print money.

Sustainability
Of course, I cannot close without some mention of the debt “sustainability” question.
I start with the situation in the US. The CBO projection, of ever rising debt to GDP andperpetual large primary de cits is not sustainable. This won’t happen. We know that. We only
don’t know how the world will be di erent: more tax revenue, less spending, in ation, default,
growth?
The CBO projections are optimistic. They are not forecasts, conditional expectations. They
enshrine parts of current law that everybody knows will change. More importantly, they assume
that nothing bad ever happens again. Notice the past debt ramped up in big waves during
2008 and 2020. The future will look more like my line, ramping up again in the next crisis andthe one after that. Except it wont, because that is even more unsustainable.

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The US and Japan do not have debt problems, they have spending problems. Japan, and theVictorian UK before her, showed that 150% or 200% debt to GDP is possible, if people havecon dence in a sober scal policy with steady small surpluses that can repay it. The US
problem is spending in excess of tax revenue. Even if we defaulted on or in ated away all our
debt today, we would still have a yawning scal gap — and a worse problem, because nobody
would lend the US any money at all. Raising tax rates to European levels will give the US
European growth. I see spending reform — we waste gargantuan amounts of money—tax
reform — more revenue at lower rates — and above all pro-growth microeconomic policy as
the only solution.
Our bond prices are still low. Clearly markets have faith that the US will in the end take these
simple steps to scal sobriety after we have tried everything else.

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In the meantime, I see the big imminent danger not in these projections, but in the potential
loss of scal space to borrow in the next crisis. If China invades Taiwan, another pandemic
breaks out, or some other crisis happens, the US will want to borrow and print a tremendous
amount of money. With no plan to pay it back, markets may refuse, producing in ation much
more quickly this time than last time, and limiting the US ability to marshal resources necessary
to ght the crisis. Debt crises always need a spark. Debt is just the gas on the oor. Debt andso far unreformed long-run spending plans make the system fragile.
Every time I give a scal theory talk, someone says “well, what about Japan?” Let me brie ysuggest some standard answers, though I hope to learn much more at this conference.
That Japan has a large debt to GDP and so far little in ation is not a “test” of the scal theoryof the price level relative to other theories. That the US has a large debt to GDP and poorde cit projections, only a little in ation so far, and moderate long-term bond prices, is not a“test” of the scal theory of the price level. If only economic theories could be so swiftly
defeated by armchair analysis.
First, who is to say that people do not expect Japanese debt to be repaid, or for my own great
country to enact simple and sensible reforms before the CBO’s projections bear out and a debt
crisis hits? Again, debt sustainability depends on debt relative to expected future ability andwill to repay, which includes interest costs. None of our indebted countries are past the ability
to repay. Indeed, the squishiness of expected future surpluses, like that of expected future
dividends, actually makes it very hard to nd testable implications of present value analysis —which makes it very hard to nd armchair rejections.
Second, debt sustainability is a necessary feature of all macroeconomic models. Old
Keynesian, new Keynesian and monetarist models all include the same condition that the valueof government debt equals the present value of surpluses. They just imagine di erent
mechanisms for this equation to hold. If it does not hold, if we could say with certainty that thepresent value of surpluses is not equal to the value of debt, then all the other theories are injust as much trouble as scal theory. Unsustainability is not a test of scal theory in favor ofmonetarist, old or new Keynesian theory.
Third, there is much new work involving r<g, liquidity values of government debt, overlapping
generations and other frictions that makes present values technically hard. I won’t address thistoday, other than to say that most of this doesn’t undermine scal theory, and much of what

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seems to is wrong. A simple example: Suppose a government nances itself only with noninterest-bearing money. Well, the rate of return on government debt, negative of the in ation
rate, is less than the growth rate. If you try to discount surpluses with that, they seem to blow
up. Yet we all know government debt is not a free lunch; if that government prints more money
to nance de cits, it gets more in ation. Liquidity values of government debt can lead one
astray in the same way.
So how has Japan gotten away with such huge debt to GDP for so long? How about the US?
Bondholders, somehow think they will be repaid, but bond markets never see crises coming. Ifthey did, the crisis just happened.
A few answers, and a few ways that Japan might actually be safer than the US, pop up. First,
consider debt:• Japan’s debt is overwhelmingly held by domestic (85%) investors. These are also morepassive than foreign nancial institutions and central banks who hold much US debt, andmight dump it. The ultimate holders are elderly Japanese people, notoriously more thrifty
than Americans, who would have sold this debt and gone on a round-the-world cruise longago.
• Japan has an estate tax, which kicks in at 10,000,000 yen, about $66,000. Some of that debt
is coming back.
• The Japanese government and central bank have a lot of assets, so the actual net debt isonly about 160% of GDP. Still “only” as large as Italy is not much comfort. Japan as a country
has run decades of trade surpluses, accumulating foreign assets. The US has done theopposite.
• Japan’s debt has a longer maturity than the US. That means it takes more time for higher
interest costs to hit the budget, and makes Japan less prone to roll over problems. Both ourcentral banks have rather dramatically shortened this maturity, however, and higher interest
costs are starting to biter.
• Low interest costs. We economists love present values, but politicians and to some extent
markets think in terms of costs. If the monthly payments are low, they carry on. I think in fact
this accounts for the large increase in debt. If markets are charging plus or, better, minus one
percent, why not borrow a huge quantity? Low interest costs have made debt sustainable. Of
course whether they will continue to do so is the big question. Higher interest costs canmake debt quickly unsustainable. (See also Chien, Cole, and Lustig 2024.)

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The underlying problem is, again, not debt, but the yawning projections of future de cits.
Those come primarily from a rapidly aging population, sharply declining birthrates, making payas-you-go pension and healthcare promises unsustainable. Which country is in more trouble?
The US has an alternative source of people — immigration, if the US will only reform its chaotic
immigration system to allow in “economic migrants,” young people who want to come, work,and pay taxes.
Japan has recently increased its consumption tax. Every time I mention “consumption tax” inthe US, an outcry follows — old people paid income and social insurance taxes when young,how dare you tax them again when they want to spend the money when they are old. Japan
did this seamlessly!
More generally, the US social insurance programs were pitched as and promised to be a“savings” program. You get out what you put in. They are slowly becoming pure transfer
programs, but that transition is politically extremely painful. For example, eliminating theincome cap on social security contributions in the US would admit it is no longer a savings
program, and just a transfer from rich to less rich. That is not entirely an easy switch, as doing
so also multiplies the disincentives of the programs. But it is the natural direction that closing
the gap may go. My understanding is that Japan’s programs were always transfer programs, soJapan does not face that limitation.
This seems to me an argument for the most important underlying question, which society will
have the social and political cohesion to undertake the simple reforms that are needed to put
our tax system and social programs on a sustainable basis?
I venture there is a greater faith in the general function and long run responsibility of scal
policy in Japan than the US, a greater reverence for repaying debt. Do not count on the US not
to default, when it comes down to checks for voters vs. principal and interest to Wall Street
and foreign central bankers.
Perhaps I’m just a starry-eyed foreigner and too aware of US political dysfunction, but I’ll chalkthat one up to Japan.

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As some evidence, I plot the best projections for Japanese debt that I could easily nd, andcontrast with the US CBO projections above. Apparently Japan has converging scal
projections.
As more evidence, here are some with some pictures from the Japanese Public Finance Fact
Sheet, Ministry of Finance. The MoF says essentially the same things I have said. I got hopefulby this report, but conference participants inform me that the MoF has been sounding thisalarm for years with little e ect. The CBO has been sounding similar alarms in the US, but theTreasury department has not, so I still nd hope that an important voice in Japanese o cial
policy understands the issues so clearly.

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Solving the long run scal problem.
Solving the long run scal gap faces some straightforward tradeo s.
One may say “just raise taxes,” but tax rates are already high. If a government spends 40% ofGDP, the average tax rate is 40%, and for everyone who pays less someone pays more.
Distortions are proportional to the square of the tax rate. It is common to say we are on the left
hand side of the La er curve, but that calculation usually considers only static labor/leisuretradeo s. The consideration for our scal situation is 20 to 50 years or more of growth, andincentives to save, invest, innovate, get education and training, and so forth. Long run growth
may be more a ected by tax rates than a one-year labor/leisure tradeo suggests.
Some social program cost cutting measures, such as raising the retirement age to match anolder and healthier population, are economically straightforward, but politically di cult. A
better way out involves social program reform — improving the large disincentives that pervade
US social programs. That can help more people at lower cost. I don’t know anything about
disincentives in Japanese social programs to say if this will help.
Some people will get less. I think it’s possible to give less to people who don’t really “need” it,recognizing that all transfers embody value judgments beyond the expertise of economists. I
think it’s possible to improve incentives so that more people don’t “need” social program help.
Remember, almost all the money goes to “middle class,” not “poor” people.

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you go old-age assistance. You have babies so there are workers to pay for your retirement.
We embarked on a social version of the ancient practice of relying on children for one’s oldage, rather than the apparently more modern practice of investing in physical capital to support
one’s old age. But we forgot that the individual incentive to have children in that system iseliminated when we rely on our collective children to support us in old age. Why raise children
to support someone else’s old age? The generation of current workers, naturally, didn’t keep
their end of the bargain. Our societies will simply not be able to provide as many pays-as-yougo transfer bene ts as we thought.
In sum, tax reform — lower marginal rates, larger base, such as a consumption tax — social
program reform — fewer disincentives to work and over-use health care — and overall
microeconomic reform to raise long-run GDP growth are the straightforward answer to thescal problem.
Moreover we live in a time of great promise. AI and biotech o er a chance at a new wave ofgrowth. But we also live in a time of great peril. Industrial policy, the new nationalist
mercantilism, tari s and subsidy wars, can explode budgets and cut o growth.
Our spending problems are internal, not external. Letting this fester to cause a debt crisis
would be a massive self-in icted disaster. Let us hope our societies live through the fragile
period and do not fall apart in this preventible way.

References
Balke, Nathan S. and Carlos E. Zarazaga, 2024. “Quantifying Fiscal Policy’s Role in U.S.
In ation” Manuscript, https://bpb-us-w2.wpmucdn.com/people.smu.edu/dist/a/1609/
les/2024/04/
Quantifying_Fiscal_Contribution_to_US_In ation_3_2024-81aa51c1758669d0.pdf
Chien, LiLi, Harold L. Cole, and Hanno N. Lustig, 2024, “What about Japan?” Stanford
University Graduate School of Business Research Paper No. 4620159 https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4620159; https://www.nber.org/papers/
w31850

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But in the end, our governments made a deal with the retiring generation: We will put in pay as

Cochrane, John H. 2023. The Fiscal Theory of the Price Level. Princeton: Princeton University
Press.

Cochrane, John H. 2024a. “Fiscal Narratives for US In ation.” Manuscript. https://www.johnhcochrane.com/research-all/sims-comment

Cochrane, John H. 2024b. “Expectations and the Neutrality of Interest Rates.” Review of
Economic Dynamics 53, 194-223. https://doi.org/10.1016/j.red.2024.04.004

Fernández-Villaverde, Jesús, Gustavo Ventura, and Wen Yao, 2024. “The Wealth of Working
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Furukawa Kakuho, Yoshihiko Hogen, Kazuki Otaka and Nao Sudo 2024. “On the Zero-In ation
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Shirakawa, Masaaki 2023. “Time for Change.” Finance and Development, International
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Smets, Frank and Raf Wouters, 2024. “Fiscal backing in ation and US business cycles”
Manuscript https://www.hoover.org/sites/default/ les/2024-04/- SW24.pdf
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