Neo Fisherianism: Crazy Trick or the Right Way Forward?

A debate has broken out on the blogs over the wisdom of an interest rate increase. Stephen Williamson, who identifies as a ‘new-monetarist’ thinks that we need to raise rates to generate inflation. Narayana Kocherlakota, who once advanced this idea himself, has now reversed his position and calls it a ‘crazy trick’.

These are two very smart people. Stephen is  a Vice President at the Federal Reserve bank of St Louis and  the author of one of the leading undergraduate textbooks in macroeconomics that is now in its 5th edition. Narayana is the former President of the Federal Reserve Bank of Minneapolis and now the Lionel W. McKenzie Professor at the University of Rochester. The fact that they have both entertained this idea at one point in the recent past suggests that it is not such a crazy trick as Narayana now suggests.

In his argument against raising rates, Narayana points out that new-monetarists, like Stephen, see the economy as self-stabilizing. Raise rates now, and the economy will soon find its way back to full employment. Perhaps there will be some minor pain along the way. But keeping rates low, or even lowering them into negative territory, is a much worse option. Just look at Japan.

According to Narayana

“…., it would be remarkably irresponsible to take the risk of raising rates based purely on a theoretical belief in macroeconomic self-stabilization.”

I am on Stephen’s side in this debate. But I do not, I repeat I DO NOT, believe that the economy is self-stabilizing. If the Fed raises rates before the private sector has begun to recover, and if that is the only change to either monetary or fiscal policy, Narayana would be right: the Fed action would derail a nascent recovery. To prevent this from happening; a rate rise must be accomplished by a simultaneous intervention in the asset markets to prevent the crash in the values of other risky and long dated asset classes that will inevitably accompany a Fed increase in the policy rate. This is what Willem Buiter has called ‘Qualitative Easing’.

Inflation is persistent in historical data. But it is not persistent because private actors are prevented from changing prices by what New-Keynesian economists refer to as ‘sticky prices’. As I explain in my forthcoming book, inflation is persistent because people's beliefs about future NGDP growth are persistent. We ARE in a low inflation trap. The way out is not through further interest rate cuts, as some have advocated. It is through a rate rise, accompanied by a fiscal/asset market intervention.

How would that be achieved? Some have argued for a money financed program of new federal and state expenditure on infrastructure. Some have argued for printing money and distributing it to the public, so-called helicopter money. I have argued for a central bank  intervention that boosts the value of risky and long-dated assets and that would increase private demand through a wealth effect. The details are secondary. The main point is that the economy is NOT self-stabilizing. Treasury actions AND the way those actions are financed, are BOTH important determinants of economic activity. If we  wait for the private sector to recover on its own; we may be waiting for a very long time.