Congress must restore the credible expectation that emergency borrowing will be followed by years of small, steady primary surpluses.

T he last four years delivered the clearest macroeconomics lesson in a generation, and it did not come from a model built in a seminar room. Instead, it came from the real world. 

Inflation broke out abruptly in early 2021 after Washington spent nearly $5 trillion in pandemic transfer payments, then layered on trillions more in peacetime stimulus spending. The Federal Reserve left interest rates pinned near zero for a year, yet prices did not spiral madly upward. And when inflation finally arrived, it eased relatively quickly, if incompletely, without the kind of deep recession that conventional doctrine predicts. As Hoover Institution economist John Cochrane explains in his new working paper called “Monetary-Fiscal Interactions,” if you think this episode can be explained solely by the timing of rate hikes or by “supply shocks,” you are looking at the wrong lever. The lever is fiscal policy.

Cochrane’s point is not ideological; it’s a sound combination of accounting and economics. The fiscal theory of the price level says the price level adjusts so that the real value of the government’s nominal debt equals the present value of future primary surpluses (i.e., tax revenues exceeding non-interest spending). When Congress issues mountains of debt without a credible plan to run surpluses, the public rationally tries to shed that paper by buying goods and services today, and the price level rises until the real value of that debt is back in line with what people expect will be repaid. From 2021 to 2023, buyers of the surge in federal debt reassessed whether future budgets would truly repay it in real terms, then shifted toward spending now. The result showed up in a rise in the consumer price index.

This interpretation also explains why the 1980s were different. Paul Volcker’s high-interest-rate campaign got the headlines, but the disinflation stuck because Congress eventually provided fiscal backing through the 1982 and 1986 tax reforms that broadened the base and lowered rates, the 1983 Social Security fix, the deregulation that fostered real economic growth, and, most importantly, larger primary surpluses to ease the fiscal burden of higher interest costs. It was a joint monetary-fiscal stabilization, not a central bank miracle. Volcker understood this well. 

As Cochrane emphasizes, the budget math is inescapable: If real rates rise to fight inflation when debt is high, interest costs go up, bondholders receive a short-term windfall, the economy softens, and deficits widen via automatic stabilizers. Unless Congress matches that arithmetic with higher future surpluses, tighter money cannot finish the job. Raising interest rates without accompanying fiscal restraint tends only to move inflation’s timing, not eliminate it.

Consider our position today. Debt held by the public is about 100 percent of GDP, not 25 percent as in 1980. The Congressional Budget Office has worried that the fiscal path is unsustainable under current law. And unfortunately, we know more crises are coming: We will have recessions, wars, or pandemics — and perhaps all three simultaneously. The last two debt surges, beginning in 2008 and then in 2020, arrived quickly and were big. What happens when the next shock hits, and Washington wants to borrow or print another $5-10 trillion on short notice while entitlement spending continues rising and Congress refuses to rein in the drivers of structural deficits? Cochrane’s warning is not that a smooth line on a budget chart will quietly explode; it is that fiscal space will surprisingly be gone precisely when we need it most. If investors, already burned by an implicit tax (also known as an “inflationary haircut”) on holders of nominal U.S. government debt in 2021-23 (for more on this, check here), doubt we can or will generate primary surpluses later, the bond market and the dollar will express that doubt in real time.

This fact is also why today’s fashion for treating the Fed as the nation’s all-purpose shock absorber is so dangerous. You can cheer or jeer each rate move, but the arithmetic doesn’t care. With debt near 100 percent of GDP, each percentage point increase in the real rate adds roughly 1 percent of GDP to annual interest-payment costs. If Congress will not backstop those costs with credible budget surpluses, the effort to squeeze inflation with higher interest rates pours fiscal gasoline on the inflation fire. That is what “fiscal dominance” means in practice: Monetary policy gets bent back toward the needs of the Treasury, rather than in the service of ensuring price stability. The surest way to preserve Fed independence is not a sternly worded letter to offices on Pennsylvania or Constitution Avenue; it is a Congress that stops asking the central bank to do what only fiscal policy can do.

We also learned something else that should humble both sides of the stale money-versus-supply shock debate. Yes, supply disruptions mattered for relative prices. But relative prices do not create a rise in the price level unless someone supplies the nominal demand. In the early 2020s, Republicans and Democrats in Washington joined forces to fuel this rise in nominal demand. Quantitative easing in the 2010s, by contrast, swapped reserves for Treasurys without increasing deficits and therefore without igniting inflation. By comparison, when the same balance-sheet expansion financed giant transfers with no credible path to repayment, it did ignite inflation. We got the kind of real-world test textbooks rarely provide, and it pointed to fiscal drivers.

What, then, is the assignment for Congress? It is not to fine-tune the Phillips Curve or second-guess the next Fed “dot plot.” It is to restore the credible expectation that emergency borrowing will be followed by years of small, steady primary surpluses. Such an expectation, not any single statute or budget score, is the anchor that will keep assets safe and inflation tame. The tools are familiar: (1) Cap and enforce genuine spending restraint, especially on items that are not true public goods, (2) revive real PAYGO so that new promises require real offsets, (3) stop pretending that tariff revenues or rosy growth projections can do the work of prioritization, and (4) above all, put the big entitlements on a sustainable trajectory with gradual, credible reforms that phase in over time so that current retirees are protected and younger workers can plan accordingly. Everything that reliably raises long-run GDP helps, such as reforms for faster permitting, broader tax bases with lower marginal rates, and genuine deregulation that targets bottlenecks as opposed to picking winners. High and rising real incomes are the least distortionary way to generate the tax-revenue surpluses that the math demands.

None of this requires austerity in the caricatured sense. It requires seriousness and sobriety. A Congress that keeps primary deficits near 5 percent of GDP is not choosing between fiscal hawkishness and dovishness. Instead, it is choosing between paying now with orderly reform or paying later with inflation, financial repression, and growth-sapping taxes imposed in a panic. If you want a simple test of seriousness, ask your congressional representative whether or not he or she would vote to restore a binding, no-gimmicks PAYGO and a real cap on the growth of primary outlays. If the answer is no, the rest is theater.

Cochrane closes by noting that the United States can handle a debt-to-GDP ratio of 100 percent if it reliably returns to small surpluses and strong growth. That is not a counsel of despair, it is a map — but maps are useful only if they are followed. Congress likes to talk about the Fed, tariffs, and the latest industrial-policy rollout. Fine. The institution that most urgently needs a policy rule is Congress itself: Borrow for genuine emergencies and productive investment, then run surpluses in good times until the debt incurred is credibly on a path toward repayment. We did it after World War II. We buttressed a disinflation in the 1980s with fiscal reforms. We can do it again. But maturity and political courage are necessary.