I noticed John Cochrane’s paper on fiscal inflation, but I did not have anything pithy to say about it. But a reader emailed and asked me to comment. The shorter version ends on this note:

If [high inflation] comes, we will see little warning, but rather a fairly sudden flight from long bonds and the dollar, followed by intractable inflation. I suspect it will be associated with stagnation, not a boom; a “loss of anchoring.”

The Fed seems to think inflation comes only from its rate choices, which affect demand and thus gaps. A fiscal inflation will come as a surprise to the Fed, as will the Fed’s inability to do much about it.

I have not worked through Cochrane’s paper, but it seems to me to resemble a Sargent-Wallace idea from nearly 30 years ago. Inflation depends on future money, and future money depends on future deficits. Hence, a fiscal theory of inflation.

The story involves expectations. The challenge is that these are not expectations of pure economic events. They are expectations about political behavior. As long as you expect Greece to muddle through or get bailed out, you do not charge them high interest rates. When you change your mind, you want to charge them not just a little more, but a lot more. The same would happen to the U.S.–a sudden shift.

I think Cochrane is telling a version of the following scenario: investors lose confidence in U.S. fiscal stability, and they sell our bonds. Our interest rates rise, which raises the cost of servicing our debt, which makes confidence in our fiscal stability fall even more. Interest rates get so high that we are effectively shut out of the bond market. So to cover our deficit, we have to print money.

It’s a scenario I’ve worried about for quite some time, although I think another desperation tactic would be a wealth tax.