John Cochrane on the Dangers of Current Economic Policies

John Cochrane

John Cochrane is the AQR Capital Management Professor of Finance at the Booth School of the University of Chicago and the incoming president of the American Finance Association. Cochrane is also author of the widely-circulated article, How did Paul Krugman get it so Wrong?, a response to Krugman’s September 2, 2009 New York Times column How Did Economists Get It So Wrong?.

Dan Richards interviewed Professor Cochrane on January 4 at the annual meeting of the American Economic Association in Atlanta, GA. This interview is one of a series that Dan conducted at that conference, and we will provide links to videos of his other interviews. Dan is president of Toronto-based Strategic Imperatives.

In some of the panels at this conference, I’ve heard a fairly dire forecast for growth in the US economy, along with pessimistic forecasts for unemployment and calls for a second fiscal stimulus. What is your mid-term outlook for the US economy?

Not as pessimistic.  But keep in mind that I never make forecasts, and therefore can never be proven wrong.  I’m going to give you an “on the one hand and on the other hand” response.

I think it’s useful to think through these questions.  Nobody knows what is going to happen – we are all thinking about what kinds of events can cause what kinds of problems.

I think the basic forecast should be pretty optimistic.  What happened to us was a very classic financial crisis and a flight to quality.  Everyone wanted cash and government bonds and weren’t spending on anything else.

That passed about six months ago. We are seeing financial markets return to normal. We are seeing all those dislocations – all that garbage in the pipes – disappear.  Historically, after panics like this, the economy grows quite quickly and comes back faster than anyone expects.  That’s what I hope will happen and what should happen.

Our dangers are from policy. There is a slight danger of additional defaults – Greece could go down and cause some more turmoil.

The big danger is that we are into astounding deficits with very large government debt.  There is a tendency for our government to micromanage and run all sorts of things.  The debt could lead to high and distorted taxes.

Debt, taxes and micromanagement leads to slow growth for a while. 

My worry is mostly on policy. The economy left alone should recover nicely.

A lot of attention is still on housing and US real estate.  Do those markets concern you?

Yes, the real estate markets could be in trouble.  But there is always a silver lining in every cloud.  A sharp decline in real estate prices is a godsend if you are 25 and have a job.  In fact, one outcome of the financial crisis is that if you are 25, you get to buy stocks a lot cheaper than I bought them.  You get to buy a house a lot cheaper than I bought one.

The decline in house prices is not per se that great a calamity.  It is very different if we lose housing wealth by prices going down than if they are washed away in a hurricane. Yet the numbers look exactly the same. 

Remember, the underlying decline in value in house prices in real estate is not that much of a problem.  Some people lose and others gain.

The problem is if the losers drag the rest of us down.  If the commercial real estate held in banks and other financial companies leads to bankruptcies and causes chaos and that leads to bailouts by the government – that is the nature of the problem, not the troubles in real estate per se.

You mentioned the broad concern related to sovereign debt.  Related to that is the follow-on concern about inflation, and the nightmare scenario is stagflation – low economic growth and inflation.  Does that concern you?

Yes, in fact my biggest worry is stagflation.  That is where I am much more pessimistic than everybody else. It is a much bigger possibility than the conventional wisdom.

There comes a moment when inflation is out of the Fed’s control. One of the big moments that will do that is when government debt poses an intolerable problem.

The Fed can only affect inflation with the background of a solvent healthy government that can easily raise taxes to pay off its debts. 

Once we get into a situation where we are worried about the US government debt, inflation comes and there is nothing the Fed can do about that.  I don’t think the Fed realizes this and I certainly don’t think most of my colleagues realize this, because we are coming off of 50 years of US history where debt was not causing a problem. 

Argentineans understand otherwise.  When your government is insolvent, you are going to have inflation and there is nothing the central bank can do about it.

That inflation will not come with a boom.  Many people assume you get rid of the slack before you can have inflation.  Bernanke says this – there is no danger of inflation because there is no slack in the economy.  Well, in 1975 there was no slack in the economy either and we got inflation.  That can happen again.