John Cochrane on Economic Puzzles and Habits of Mind

John Cochrane — financial economist, Hoover senior fellow, author of the graduate textbook Asset Pricing, and blogger as ‘The Grumpy Economist’ — joins Tyler Cowen in Ep. 117 to work through a string of finance and macro puzzles: why real interest rates never equalise across countries, why asset prices swing far more than fundamentals, why so much money chases active management, how inflation really arises, and what a single uniting habit of mind ties it all together. Recorded 4 January 2021.

Key ideas

1. Apparent profit is not arbitrage; it is risk you cannot yet name. Arbitrage means a sure profit with no risk — and that is not what Brazil’s decades of high real interest rates offer. (A real interest rate is the return after stripping out inflation and expected currency moves.) When Cowen presses on why high-return opportunities across countries do not get competed away, Cochrane’s answer is that finance is littered with patterns that look free but carry risks economists cannot fully suss out. When such strategies fail, they fail all at once. The discipline is to resist judging the ‘right’ price from an armchair.
2. Asset prices move on discount-rate news, not cash-flow news. A discount rate is the rate at which future money is marked down to its value today; a higher discount rate means a lower price now. Cochrane’s central empirical claim is that stock and bond prices swing far more than any forecast of future dividends or earnings can justify — the movement comes from changing discount rates, which is another way of saying the risk premium (the extra return investors demand for bearing risk) rises and falls. This implies money can be made buying when prices are low and selling when high, if you can wait a long time.
3. The equity premium reflects time-varying fear, not a stable risk gap. The equity premium is the long-run excess of stock returns over safe bonds. The habit-formation model Cochrane wrote with John Campbell does not really explain its level, he concedes — what it captures is recessions. A recession is when people get scared, their effective risk aversion spikes, and they flee risky assets, so markets fall far more than the real economy does. Losing income relative to what you are used to feels like disaster even at objectively high living standards.
4. The fiscal theory: inflation comes when faith in the government’s debt fails. The fiscal theory of the price level holds that money has value because the government can soak it up through future taxes; the price level adjusts so the real value of nominal debt equals the present value of future primary surpluses. Inflation, on this view, is not the Fed printing money but people losing confidence that debt will be repaid, dumping it for goods. The risk for the US is a sudden roll-over crisis — an unforecastable run, like a bank run, not a slow slide.
5. One simple structure, applied everywhere — that is the habit of mind. Cochrane reduces problems to a few fundamental principles and a logical spine: Asset Pricing opens with one equation; the fiscal theory book runs all of monetary policy off a single present-value equation; he even applied optimal-portfolio theory to optimal gliding. He frames the title’s theme as self-knowledge about how one’s own mind works — and admires the historian’s and mathematician’s opposite gifts that he lacks.

Content

Why real interest rates do not equalise across countries

Cowen opens with a puzzle that has long bothered him: Brazil has run very high real interest rates for decades, yet capital does not flood in to compete them away. Cochrane’s first move is to deny it is arbitrage at all. Arbitrage is a sure profit with no risk; investing in Brazil means bearing currency risk and the legal risk of expropriation. The high return is compensation for risks that may be hard to identify but are real — and the proof is in the wreckage of hedge funds that chased the trade and blew up together. He widens the lens to uncovered interest parity (high-rate currencies do not depreciate as theory predicts, but when the trade goes wrong it goes wrong catastrophically) and to the broader pattern of cross-border capital flows that ‘bedevil us free marketers’. His methodological discomfort is the point: a free-market economist should not be in the business of declaring the market’s price wrong from a coffee table — a discipline he attributes to Hayek.

What the forecasters get wrong about low rates

Pushed on why expert forecasters have been wrong about real rates for decades, Cochrane resists looking inside other people’s heads (‘another bad intellectual habit’). He offers instead the fundamentals that make low rates sensible: a low-growth economy has fewer investment opportunities and therefore lower returns on capital — ‘the first principle of macroeconomics’. Add low and anchored inflation, which removes inflation risk, and the special safety of dollar bonds — they rise in every recession, which makes them valuable insurance — and persistently low rates stop looking like a puzzle. He flags this as armchair theorising he distrusts even as he supplies it.

Active management, trading volume, and the efficiency paradox

Cowen asks whether the sheer scale of active management and trading proves markets are inefficient. Cochrane separates the two questions. On active management: it has been scientifically settled since the 1960s that high-fee managers do not beat a low-cost index, yet people have paid for it for fifty years — a genuine Chicago-school embarrassment, slowly resolving as money moves to passive index funds. But this hits the efficiency paradox: if everyone indexed, no one would gather the information that makes prices efficient, so markets must stay slightly inefficient and someone must trade. On trading volume, he is more troubled. Ordinary investors trade rarely, yet stocks turn over a hundred times — he lists ‘why does getting information into prices require this’ among the great unsolved puzzles he hopes his grandchildren will crack. He resists writing it off as human folly but admits there is no good model.

Where finance is going: from behaviour to plumbing

A reader asks where the next great innovation in finance will come from, given the golden age of CAPM, Black–Scholes, and prospect theory. Cochrane first punctures the nostalgia — every generation thinks the last one was the golden age, and Lucas’s Chicago cohort felt like wilderness exiles in their own great era. What excites him now is the turn from behavioural finance (psychological imperfections at the heart of everything) toward institutional finance — the ‘plumbing’ of who is actually active in markets, how banks’ balance sheets look, how order flow moves prices. The plumbing failed visibly in 2008, and the astonishing fact it exposed is that demand moves prices: a wave of orders pushes prices up, which textbook finance says should not happen. That is the live frontier.

The fiscal theory of the price level

Cowen plunges into the fiscal theory, the subject of Cochrane’s then-600-page book in progress. The plain version: money gains value because the government can charge taxes to soak it back up, so the distinction between money and government bonds matters less than total government debt and the government’s ability to repay. Inflation arrives when people lose faith in repayment, try to dump the debt, and bid up the price of goods. On the much-discussed ‘r less than g’ question (interest rate below growth rate), Cochrane reframes it as debt sustainability rather than fiscal theory proper. If you could borrow forever and roll the debt over while the economy outgrew the interest, debt would shrink on its own — a ‘money machine’ where no one works or pays taxes. Plainly that is false; the question is why. His answer: an r one point below g buys roughly one per cent of GDP for free, but the US is borrowing five per cent of GDP forever, so the excess must be repaid by taxes — and if it is not, people dump the debt and inflation follows.

Predictions, runs, and the powder keg

Asked the fiscal theory’s prediction for pandemic-era inflation, Cochrane insists economics makes conditional predictions only — ‘if x, holding all else constant, then y’ — not unconditional forecasts. The theory does not specially forecast inflation; it opens the possibility that unsustainable debt ends in sharp inflation rather than default. Having built up enormous debt, the US risks a roll-over crisis: bond markets look at the next ten trillion of borrowing and say ‘we’re done’, and what looked sustainable suddenly is not. Like a bank run or an earthquake, it is inherently unpredictable — if you could forecast it, it would already have happened. This ties back to his deeper claim: interest rates have never forecast inflation (not high before the 1970s inflation, not low before the 1980s disinflation); rates, like exchange rates, behave like a random walk. Prices move on discount-rate news, not fundamentals.

Crypto and the limits of efficiency

Cowen says he once thought crypto would fall to zero by arbitrage and now doubts it; Cochrane thinks he was right the first time. Bitcoin is pure fiat money with no government able to tax to support it — valuable only for its liquidity use (anonymous transactions) and its limited supply. But nothing stops substitutes or derivative claims that trade just like it, so its value must eventually go to zero. The crucial subtlety: a market can be very nearly efficient in rate of return yet wildly inefficient in price. Shorting Bitcoin fails because it can rise for years before falling, and even a tenth of a per cent annual cost to hold the short, plus mark-to-market losses along the way, lets the price stay far out of line. A one-per-cent inefficiency in return can be a factor of two or three in price — ‘we see that all over the place’. When Cowen counters with the Patinkin world of imperfect substitutes and downward-sloping money demand, Cochrane holds firm: the fiscal theory allows liquidity spreads, but since the government no longer controls the money supply, those spreads only nudge interest rates — they do not set the price level.

Health insurance, gliding, and the uniting habit

The conversation ranges further: Cochrane’s ‘health-status insurance’ (insure against the future risk of becoming expensive to insure — once offered, then banned), which he argues markets can supply just as term-life insurance already does, with the government stepping in only for known genetic conditions via a lump sum; the cross-subsidy ‘original sin’ that kills competition in healthcare; his 2004 national gliding championship and the FAA’s strangling of general aviation; and his diagnosis of why non-competitive institutions drift left. The closing thread is methodological. Asked how the finance economist, the policy reformer, and the glider pilot fit together, Cochrane names one habit of mind: reduce everything to a few principles and a logical structure. Physics over chemistry as a student; one equation at the head of Asset Pricing; portfolio theory applied to gliding; all of monetary policy run off one present-value equation. He admires the historian’s memory and the mathematician’s structural vision he does not possess, and credits his historian father and translator mother’s dinner table for teaching him to think.

Related

• John Cochrane — speaker; financial economist, Hoover senior fellow, author of Asset Pricing
• Tyler Cowen — host
• Daron Acemoglu on the Struggle Between State and Society — Conversations with Tyler, Ep. 81; companion economics episode on the same show
• Matt Levine on Finance, Markets, and Financial Writing — related episode on markets, finance, and what really moves prices
• Cliff Asness on Momentum, Value Investing, and Market Efficiency — Asness and Cochrane share the Chicago efficient-markets tradition and the debate over market efficiency
• Bill Ackman on Activist Investing, Concentrated Bets, and Financial Battles — related finance episode from the same ingest cycle