How to Stop Worrying and Love Bonds

DONALD TRUMP’S PROPOSALS WOULD RUN UP THE DEFICIT. WHAT WILL THAT DO TO YOUR BONDS? JOHN COCHRANE’S FISCAL THEORY POINTS TO AN ANSWER.

- WILLIAM BALDWIN

What drives inflation?

Too much money, say the monetarists. When growth in the money supply exceeds growth in output, Milton Friedman declared, prices go up.

That's not quite right, say some dissident economists gathering under the banner of "fiscal theory." The bigger factor, they say, is deficit spending. More precisely: federal deficits unaccompanied by any prospect of an eventual paydown.

If the fiscal theorists are right, the future for holders of the usual kind of bonds, the ones without any inflation protection, is dark, even without any inflationary pressure that might come from increased tariffs. The Committee for a Responsible Federal Budget estimates President-elect Trump's policies would add $7.8 trillion to the federal debt over a decade.

John H. Cochrane, a 67-year-old economist at Stanford University's Hoover Institution, author of the 584-page Fiscal Theory of the Price Level (2023) and opinionated commentator on the blog "Grumpy Economist," is probably the most vocal of fiscal theory's proponents. It's not merely the deficit number that determines inflation, he says. It's how the market perceives the excess spending.

For two centuries the U.S. Treasury mostly borrowed like a responsible credit card user, running up debt to cover an exigency, like war or recession, and then paying it down, or at least seeing it decline in relation to GDP. That pattern has now broken down.

Although the financial crisis of 2008-09 looked like a one-off event and the bonds issued to combat it were readily swallowed by investors, the Covid episode was another matter, Cochrane says. The $5 trillion dished out to make up for lockdowns looked like a freebie that the populace was never going to pay back to the tax collector.