Raphael Stevens

Imagine it is late 2024. Inflation in the rich world has fallen from its peak but stayed stubbornly high. At around 4%, it is well above the level at which most central banks are comfortable. Governments, weighed down by vast debts, must use precious revenues to pay interest on the debt, which itself is growing because of high interest rates. The energy transition and rising state spending owing to ageing populations add to the fiscal largesse. Raising taxes is politically fraught, so more money is printed. Inflation stays high and governments’ credibility worsens. Central bankers are scratching their heads, wondering how their powerful weapon—the interest rate—has failed so thoroughly.A wonkish theory, laid out in glorious detail in a new book by John Cochrane of Stanford University’s Hoover Institution, would offer a potential explanation. “The Fiscal Theory of the Price Level” builds a theory of inflation as ambitious as that proposed by John Maynard Keynes’s “The General Theory” or Milton Friedman’s and Anna Schwartz’s “A Monetary History”. Mr Cochrane, whose own work on the subject spans four decades, spends nearly 600 pages reworking the maths of past economic models to incorporate fiscal theory, while chattily discussing how it explains past inflationary episodes. “[E]ven Milton Friedman might change his mind with new facts and experience at hand,” he speculates.At the heart of Mr Cochrane’s theory is the idea that government debt can be valued like a firm’s equity, based on the returns to its owner’s pockets. The price level will adjust—and therefore drive inflation or deflation—to ensure that the real value of the debt equals the sum of a government’s future budget surpluses, appropriately discounted. Thus the true driver of inflation is government debt not monetary policy. Under this theory, money is valuable because it can be used to pay tax and generate surpluses. The set-up is not all that different from the gold standard, except it is tax, rather than gold, that backs money. Mr Cochrane is careful to note that the adjustment of the price level is not instantaneous. People can be poor judges of a government’s credibility when it comes to paying off debts. Just like stocks, prices are able to deviate from fundamentals. Yet in the long run, they adjust. A government that hands out money without eventually running surpluses will not avoid inflation for ever. History appears to offer support. Brad DeLong of the University of California, Berkeley, uses fiscal theory in his recent book, “Slouching towards Utopia”, to explain inflation in post-first-world-war Europe. In France hefty debt-interest payments led to an average of 20% annual inflation over seven years. In Germany things were worse. The public lost faith in the ability of the state to pay off its debts without inflation. Soon hyperinflation kicked in. Mr Cochrane also brings fiscal theory to bear on America’s inflation in the 1970s-80s. In the mid-1970s price rises exceeded 12%. The Federal Reserve lifted interest rates; inflation dropped to 5% by 1977. Yet Mr Cochrane points out that inflation shot up again to more than 14% by 1980, in part because America failed to get its fiscal house in order. Fiscal and regulatory reforms that raised expectations of future surpluses, along with another dose of monetary medicine, were needed to vanquish inflation.How is fiscal theory faring today? For a decade after the global financial crisis of 2007-09, prices stayed stubbornly low despite a ballooning supply of money and interest rates sitting at or below zero in much of the rich world. A “crude monetarism” predicted an inflationary surge, which did not materialise. Other revamped “New Keynesian” models also proved unhelpful. When governments spent big during the covid-19 pandemic, many economists, reasoning from recent history, were sanguine about the possibility of inflation.Mr Cochrane argues fiscal theory can explain both the period of low inflation and the return of rapidly rising prices after the pandemic. Inflation was meagre in the 2010s, despite soaring government debts, because politicians promised to get their books in order and low interest rates meant consumers and bondholders were willing to wait. Yet during the pandemic, governments took a different approach. They dropped enormous cheques into consumers’ pockets. The Fed purchased government debt immediately after its issuance. There was little talk of sustainability. Mr Cochrane argues that the direct nature of these “helicopter drops” informed people their newly fat pockets would not be drained by future taxes. Thus they were more willing to spend.Heads I win, tails you loseThis story is perhaps too convenient. Indeed, Mr Cochrane admits that fiscal theory’s flaw is it offers a way of explaining nearly any series of historical events in an unfalsifiable manner. Yes, other theories of inflation have problems. But if it is so hard to prove fiscal theory wrong, are they really in a fair fight? Mr Cochrane’s story of how inflation ended in the 1980s is complicated by the fact that America actually cut taxes, suggesting politicians were not all that concerned by balanced budgets. Although deregulation may have boosted growth, many economists think the budget surpluses of the 1990s were mainly caused by globalisation and an it boom, which few consumers in the 1980s saw coming.Fiscal theory also offers limited guidance to policymakers beyond what is already well-known. Under its approach, monetary policy remains important: interest rates can spread out an increase in the price level over a period of time. In addition, the theory suggests governments must maintain credibility when it comes to paying off their debts—hardly a radical idea. Fast-forward once again to late 2024. Imagine this time inflation has fallen to 2%. Interest rates are slowly coming down. Central bankers are running a victory lap. What of fiscal theory? Its supporters might take a victory lap, too, just as they would have done if inflation had remained high. ■Read more from Free Exchange, our column on economics:Could Europe end up with a worse inflation problem than America? (Jan 19th)Warnings from history for a new era of industrial policy (Jan 11th)The Federal Reserve’s great anti-hero deserves a second look (Dec 20th)For more expert analysis of the biggest stories in economics, finance and markets, sign up to Money Talks, our weekly subscriber-only newsletter. More

Is it possible to manage money successfully and be a virtuous Christian? For 2,000-odd years, followers of the world’s largest religion have debated the issue. Recently the debate has become fractious. The management of Christian money, once farmed out to professionals, is now a moral minefield, the negotiation of which has effects in the here-and-now, not just the hereafter. Christian investors mostly fall into three camps: those willing to forge a partnership with environmental, social and governance (esg) types; those stridently opposed to them; and Roman Catholics. Dave Zellner, who manages $24bn for Wespath, in effect the investment arm of America’s Methodists, is in the first. He calls his job a search for “the intersection between good business practice and church values”. Wespath lends to housing projects for the poor, but at market rates. It teams up with worldly lobby groups for shareholder activism, including a coalition called Climate Action 100+ which encourages energy companies to quit carbon. Robert Netzly, an American evangelical, is Mr Zellner’s mirror image. His firm, Inspire Investing, manages $2bn. It seeks to apply “Biblical principles” to all choices. Last year Mr Netzly renounced the esg label, saying it was “weaponised by liberal activists to push forward their…social-Marxist agenda”. But he agrees with esg advocates that non-financial criteria should be used to consider investments—he just employs different criteria, such as whether firms support abortion by, say, funding travel for employees’ procedures. He also engages in shareholder activism, pushing banks to accept business from religious conservatives. Properly mobilised, he says, the Christian investment industry could be powerful. He places the stock and bond holdings of America’s Catholics and Protestants at roughly $21trn. Straddling this chasm is the Roman Catholic church. In November Peter Turkson, a cardinal, issued the Vatican’s highest-level statement on where money should be directed. Its list of 24 things to avoid abetting where possible is broad: addictive products and pornography; embryo research, which conservatives hate; and genetically modified seeds, opposed by ecoleftists. In America, where Catholic bishops have issued their own rules, some conservative scholars called the paper muddled.Dylan Pahman of the Acton Institute, a religious think-thank, argues churches are delving too deeply into economics. Although it is right to cherish the planet, for instance, energy policies involve trade-offs and calculating them is not the business of theology, he says. Given the rancour of today’s debate, his is likely to remain a voice in the wilderness.For more expert analysis of the biggest stories in economics, finance and markets, sign up to Money Talks, our weekly subscriber-only newsletter. More

For much of the past two years, economists have argued fiercely about prices. As inflation in America and elsewhere has exceeded central-bank targets, analysts have dissected different components of the cost of living, including the prices of goods, services, energy and rents. But what about the Big Mac? The iconic McDonald’s burger is an amalgam of rent, electricity and labour, as well as beef, bread and cheese. Its price is therefore indicative of broader inflationary pressures. And because the burger is basically the same wherever you are in the world, its price can also reveal how inflation has changed the relative costliness of different countries.In America, for example, the median price of a Big Mac has risen by more than 6% to an average of $5.36 in the past two years. (The price tends to be a bit higher in big cities.) According to the theory of purchasing-power parity, when a country’s prices rise, its currency should fall, everything else equal. This stops the country’s prices moving too far out of line with those elsewhere in the world. Yet the dollar has risen, not fallen, over the past two years against the currencies of most other big economies. A trade-weighted exchange-rate index published by America’s Federal Reserve increased by more than 9% from December 2020 to December 2022. One reason for this is that inflation has also returned to lots of America’s trading partners. Indeed, in many places it is worse. Big Mac prices have risen by 14% over the past two years in the euro area and by 15% in Britain. But the dollar’s rise against the euro and pound has been more than required to offset this inflation gap.The combination of rising prices and a rising currency threatens to move American prices out of whack with those elsewhere in the world. Two years ago, for example, the Big Mac was 26% cheaper in Japan than America. In principle, this suggests the yen was undervalued and should have risen against the dollar. In fact, the opposite occurred. A Big Mac is now more than 40% cheaper in Japan. There are exceptions where the theory of purchasing-power parity has held. Although Argentina’s peso has fallen against the dollar, prices in the country have risen even faster. A Big Mac now costs the equivalent of $5.31. That is high compared with the price two years ago and also compared with today’s price in Brazil ($4.44). If the two Latin American countries were to form a currency union at today’s exchange rate, Argentina would find itself at a hefty competitive disadvantage. It would be almost 20% more expensive than its larger neighbour, at least judging by burger prices.The Economist has been making comparisons of this kind since 1986. Converting Big Mac prices into dollars always reveals big differences in the cost of the same burger in different countries. One measure of the “fair value” of a currency is the exchange rate that would eliminate these gaps. But, of course, exchange rates are not the only thing that can adjust. Prices can also rise faster in one country than another. In the long era of low inflation, this was not where the action was. Over the past two years, prices have been on the move in many countries. Unfortunately, these bouts of inflation have done little to move burger prices closer together. ■For more expert analysis of the biggest stories in economics, finance and markets, sign up to Money Talks, our weekly subscriber-only newsletter. More

Last year’s plunging markets left few investors smiling. Stocks and bonds fell in tandem; haven assets failed to offer safe harbour. Doing well meant making single-figure percentage losses rather than double. It might, therefore, seem an odd time for fund managers to be walking with a spring in their step. But on January 23rd it emerged that Citadel, a secretive investment firm based in Miami, had generated $16bn in net profits for its clients in 2022, breaking the record for the largest annual gain in dollar terms. Its main hedge fund posted a 38% return—while msci’s broadest index of global stocks declined by 18%. Champagne corks were popping elsewhere, too. Strategas Securities, a brokerage and research firm, reckons that 62% of active fund managers investing in large American firms beat the s&p 500 index of such shares in 2022, the highest percentage since 2005. Last year therefore snapped a miserable losing streak for stockpickers. Every year from 2010 to 2021, more than half of active managers who benchmarked their performance against the s&p 500 failed to beat it. In other words, the average fund manager was outclassed by a simple algorithm blindly buying every stock in the index. Such algorithms—known as “passive” or “index” funds—are taking over. By 2021 they held 43% of the assets managed by American investment companies, and owned a greater share of the country’s stockmarket than their actively managed counterparts.The logic that drives passive funds is inescapable. By definition, the performance of an index is the average of those who own the underlying stocks. Beating an index is a zero-sum game. If one investor does, another must lose out. Active managers may spot a superstar stock that ends up leaving the rest in the dust. But it will also be in the index, so passive investors will buy it too. Meanwhile, active managers tend to charge fees that are orders of magnitude higher than passive ones: often 1-2% a year, and more for whizzy hedge funds, compared with as little as 0.03% for their algorithmic peers. This drag on performance makes it all but inevitable that index funds will outpace human money managers in the long run.So how did fund managers outperform in 2022? One possibility is sheer luck. Pick a group of stocks from an index at random, subtract a percentage point or two from their returns for fees, and occasionally you will have chosen shares that do well enough to beat the average.A variation on this allows for some skill on the stockpicker’s part. At the start of 2022, Alphabet, Amazon, Apple, Microsoft and Tesla accounted for nearly a quarter of the total market capitalisation of the s&p 500. Their collective value dropped by 38% over the year; that of the rest of the index dropped by just 15%. So concentrated was the index that a single good judgment—thinking the shares of America’s tech giants were frothy and to be avoided—would have left a stockpicker with a decent chance of beating the market.Broadening out this tech queasiness to a more general worry about stock valuations would have given stockpickers a second chance to outperform. Quibbling about such things went out of fashion during the years of cheap money that followed the global financial crisis of 2007-09 and then covid-19. Share prices soared to eye-watering multiples of the underlying companies’ earnings or assets, then kept climbing. Those who took that as a signal to shun them, in anticipation of a correction, lost out. Passive funds that indiscriminately bought everything, including stocks which seemed overpriced, prospered. But in 2022 rising interest rates brought the trend to an abrupt halt. Investors who had hunted for stocks that were cheap relative to their fundamentals were at last rewarded.For firms like Citadel, a final chance to prove their worth came from plummeting share and bond prices. Market crashes and an uncertain economic backdrop are the raison d’être for hedge funds with a mandate to invest in any asset class they wish. Stockmarket indices that are falling by double digits are a lot easier to beat if you aren’t obliged to buy stocks, as are the funds which track the market. And for the most nimble managers, last year’s crises looked like opportunities. As a convulsing sovereign-debt market forced British pension funds into fire-sales in September, Apollo, a private-investment firm, started snapping up assets to book a quick profit. Index funds are not going away, and nor should they. But just occasionally, active managers are worth their fees.Read more from Buttonwood, our columnist on financial markets:Venture capital’s $300bn question (Jan 18th)The dollar could bring investors a nasty surprise (Jan 12th)Will investors have another awful year in 2023? (Jan 5th)For more expert analysis of the biggest stories in economics, finance and markets, sign up to Money Talks, our weekly subscriber-only newsletter. More

Argentina is running out of vaults. With annual inflation nearing 100%, as the central bank prints bills to cover the government’s fiscal deficit, local banks are making space for ballooning stocks of pesos. Officials have tightened capital controls. Imports are at a standstill. The government is going through the motions with the imf to avoid its tenth sovereign default since independence in 1816. Yet on January 22nd Luiz Inácio Lula da Silva, Brazil’s president, and Alberto Fernández, his Argentine counterpart, announced they would start preparations for a common currency, possibly leading to a full currency union, which would hitch South America’s biggest economy to one of its sickest.The idea has a history. First came the “gaucho”, a currency meant to replace Brazil’s cruzado and Argentina’s austral until the concept was abandoned amid economic turmoil in 1988. On its heels was a proposal by members of Mercosur, a trade alliance, to adopt a common currency, and sucre, an experiment led by Venezuela, which had ambitions to reduce the continent’s reliance on the dollar. Since it is prone to selling foreign reserves to prop up the peso, Argentina is always short of dollars to settle loans and pay for imports. A joint currency would create alternative reserves and make neighbourly trade easier. Brazil is Argentina’s largest trading partner. By supporting the idea Lula, as Mr Silva is known, gets a reputational boost from being seen to revive regional co-operation. That, at least, is the case for the idea. The case against is daunting. A full union, with a joint central bank, would surely crumble. Economists judge how well countries fit in a currency union using criteria devised by Robert Mundell, a Canadian economist, that measure economic similarities. Normally, central bankers tailor interest rates to individual economies; in a union, one rate has to do for them all. Policy rates in Argentina and Brazil are an astonishing 61 percentage points apart. Their business cycles are wildly out of sync as their main exports—agriculture and industrial commodities, respectively—are affected by different global headwinds. Argentina’s problems make its downturns deeper and booms shorter and shallower. Another condition specified by Mundell is that people and money should move smoothly across borders, acting as a means of adjustment when a shock hits one country but not the other. Whereas in Europe farm workers hop between jobs and countries, South America’s poor infrastructure makes travel a hassle, and Argentina’s capital controls make getting paid across borders nearly impossible. If workers do not end up where they are most productive, artificially high wages could spark inflation in parts of the union. Moreover, as long as Brazil was committed to the joint currency, it would be forced to bail out its southern neighbour. Secure in that knowledge, Argentina would have every reason to carry on spending irresponsibly. Brazil is already getting cold feet. Officials have stressed the new currency would be an addition to the two national ones, rather than a replacement, and that it is a long-term project. Other countries are not racing to join. Lula and Mr Fernández offered South American leaders the chance to do so at a press conference on January 25th: no one has so far taken them up. This watered-down union would still place Argentina’s problems at Brazil’s door. There would need to be a monetary policymaker, either a currency board or full-blown central bank, to watch exchange rates. The imf, to which Argentina owes $72bn, would be less willing to prop up the peso if Argentina had another legal tender. To top it all off, Lula would have to ignore his independent central bank, which has come out in opposition to the idea. On January 23rd, barely 24 hours after the grand announcement, Fernando Haddad, Brazil’s finance minister, implied the idea would only get off the ground as notes of credit that were backed by Argentinian commodities. That would not be currency at all. But it would be more borrowing, which is exactly what Argentina set out to avoid. ■For more expert analysis of the biggest stories in economics, finance and markets, sign up to Money Talks, our weekly subscriber-only newsletter. More