Ricardo Nunes of University of Surrey, CIMS, and CfM reviews “The Fiscal Theory of the Price Level” by John H. Cochrane. The Econlit abstract of this book begins: “Considers ways to make fiscal theory accessible, developing stories and intuition for how it can help facilitate an understanding of the world. Explores a simple two-period fiscal theory model with perfectly flexible prices, constant interest rates, short-term debt, and no risk premiums, in addition to a simple intertemporal model.”

This article develops a model of optimal government debt maturity in which the government cannot issue state-contingent bonds and cannot commit to fiscal policy. If the government can perfectly commit, it fully insulates the economy against government spending shocks by purchasing short-term assets and issuing long-term debt. These positions are quantitatively very large relative to GDP and do not need to be actively managed by the government. Our main result is that these conclusions are not robust to the introduction of lack of commitment. Under lack of commitment, large and tilted debt positions are very expensive to finance ex ante since they exacerbate the problem of lack of commitment ex post. In contrast, a flat maturity structure minimizes the cost of lack of commitment, though it also limits insurance and increases the volatility of fiscal policy distortions. We show that the optimal time-consistent maturity structure is nearly flat because reducing average borrowing costs is quantitatively more important for welfare than reducing fiscal policy volatility. Thus, under lack of commitment, the government actively manages its debt positions and can approximate optimal policy by confining its debt instruments to consols.

According to the Lucas-Stokey result, a government can structure its debt maturity to guarantee commitment to optimal fiscal policy by future governments. In this paper, we overturn this conclusion, showing that it does not generally hold in the same model and under the same definition of time consistency as in Lucas-Stokey. Our argument rests on the existence of an overlooked commitment problem that cannot be remedied with debt maturity: a government in the future will not necessarily tax above the peak of the Laffer curve, even if it is ex ante optimal to do so.