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Aaron Steelman interviews Erik Hurst in Econ Focus, published by the Federal Reserve Bank of Richmond (First Quarter 2016, pp. 22-26). The brief overview preceding the actual interview describes some of the subjects covered:

\”Hurst has used regional data in a series of papers to look at other macroeconomic phenomena that would be hard to examine using national data alone. He also has done important work on household financial behavior — including consumption and time use over people\’s life cycles — and on labor markets. Business startups have been another interest of his: Much has been written about the importance of entrepreneurship to the U.S. economy, but what, he has asked, actually motivates people to open their own businesses? In addition, in a recent paper, he and co-authors have attempted to quantify how much the decline in barriers to employment of women and minorities has contributed to economic growth. Among his current research interests is explaining the decline in labor force participation among prime working age males.\”

Here are a few of Hurst\’s comments from the interview that caught my eye:

On who the entrepreneurs really are …

\”Most small businesses are plumbers and dry cleaners and local shopkeepers and house painters. These are great and important occupations, but empirically essentially none of them grow. They start small and stay small well into their life cycle. A plumber often starts out by himself and then hires just one or two people. And when you ask them if they want to be big over time, they say no. That\’s not their ambition. This is important because a lot of our models assume businesses want to grow. Thinking most small businesses are like Google is not even close to being accurate. They are a tiny fraction.

\”My work with Ben Pugsley has been emphasizing the importance of nonpecuniary benefits to small-business formation. Because when you ask small-business people what their favorite part of their job is, it\’s not making a lot of money. They do earn an income and they\’re very happy with it, but they get even more satisfaction from being their own boss and having flexibility and all of those other nonpecuniary benefits that come with being the median entrepreneur in the United States.\”

Wages may be flexible at the local/regional level, even if they appear stickier using national-level data. 

The facts are real wages moved very strongly with employment across regions. Nevada was hit very hard by the recession, for example, while Texas was hit much less hard. Wage growth, both nominal and real, was about 5 percent higher in Texas than it was in Nevada during the Great Recession. So if you\’re going to just correlate employment movements and wage movements, both real and nominal, at the local level, you see a pretty strong reduced form correlation.In the aggregate time series, you don\’t. Wages hardly moved at all despite employment falling pretty sharply. So there are some differences in the correlations between wages and employment at the local level and the aggregate level during this recession … When people say the reason we haven\’t seen real robust wage growth in the recovery is because wages were so sticky in the beginning period, I just don\’t think that holds water with the flexibility of wages that we see at the local level.\”

The Great Recession is over–for skilled labor.

\”There is a structural problem for prime-age, lower-skilled workers in the economy. If you take a look at people with a four-year college degree, you can barely see the effects of the recession any longer. There’s been no lasting effect on their employment rate. Almost all of the effect is concentrated among people with less than four-year college degrees.\”

Do the agglomeration benefits of urban areas come from production or from consumption?

\”Many urban models historically assumed that agglomeration benefits usually came from the firm side. Someone might want to be close to the center city, for instance, because most firms are located in the center city. So the spillover for the household was the commuting time to where the firms were, and the firms chose to locate near each other because of agglomeration benefits.

\”I have always been interested in it from another angle. When we all come together as individuals, we may create agglomeration forces that produce positive or negative consumption amenities. Thinking about it this way, when a lot of high-income people live together, maybe there are better schools because of peer effects or higher taxes. Or maybe there are more restaurants because restaurants are generally a luxury good. Or maybe there’s less crime because there is an inverse relationships between neighborhood income and crime, which empirically seems to hold. So, while we value proximity to firms, that’s not the only thing we value. How important are these consumption amenities? And more importantly, how do these consumption amenities evolve over time …\”

The interview also discuss the findings of several paper that appeared in the Journal of Economic Perspectives, where I work as Managing Editor, and which together give a sense of the breadth and depth of Hurst\’s work. (All papers in JEP, from the current issue back to the first issue in 1987, are freely available online compliments of the publisher, the American Economic Association.\”

In the Summer 2008 issue of JEP, Hurst co-authored a paper with Jonathan Guryan and Melissa Kearney on the subject, \”Parental Education and Parental Time with Children.\” Here\’s a comment from Hurst about this work in the interview:

\”[I]f you look at the income gradient of how we spend our time, the richer you are, the less home production you do. But the richer you are, the more childcare you do. So that income gradient between home production and childcare has opposite signs, which tells me it’s not exactly the same good. Whether that’s coming from the utility you get from being with your kids or whether it’s from investing in their human capital, that’s hard to say. We know people from high-income families go to school more, go to the doctor more, and spend more time with their families. So how much of it is investment, how much of it is home production, how much is leisure, I don’t know.

\”I have always advocated that you should have four uses of time — market work, home production, taking care of kids, and leisure — and then treat kids as somewhere between leisure and home production.\”

In the Spring 2016 issue of JEP, Hurst co-authored a paper with Kerwin Kofi Charles and Matthew J. Notowidigdo on the subject \”The Masking of the Decline in Manufacturing Employment by the Housing Bubble.\” Here\’s Hurst describing the paper:

\”The way I usually describe the paper, which I wrote with Kerwin Charles and Matt Notowidigdo, is to take two regions, Detroit and Las Vegas. Las Vegas has very little manufacturing relative to Detroit. Detroit didn’t have a big housing boom but Las Vegas did. … When you look at this early 2000s period, if you focus only on Detroit, you see employment rates going down, particularly among prime-age workers. It looks like there was a structural decline in employment well before the recession ever started. When you look at Las Vegas during the boom, the employment rate was well above long-run local averages. Normally, most people in their 20s and 30s work, but some of them don’t. During this period in Las Vegas, among lower-skilled workers in their 20s and 30s, nearly everybody was working. So when you put aggregate statistics together, when you sum together Detroit and Las Vegas, it looks like employment rates were relatively constant over this time period. But one was really low compared to historical levels, and one was really high relative to historical levels.

\”In this paper, we show that the decline in manufacturing that occurred during this period nationally — when you add in the Detroits, the Worcesters, and the Youngstowns — was masked by the aggregate housing boom in places like Las Vegas, Phoenix, south Florida, and some places in California that were growing well above average. Now one of these was temporary and one isn’t. The housing boom we know busted and then employment in Las Vegas plummeted. If you look at 2010 or 2011, the employment rate in Las Vegas is roughly the same as it was in 2000, meaning it increased and went back to trend, where the old manufacturing centers just continued declining relative to their 2000 level. You have a very temporary boom-bust cycle overlaid with a structural decline, and what you get is kind of a hockey stick pattern for the aggregate.

\”So for macroeconomists looking at the Great Recession, this is important for understanding why the employment rate hasn’t bounced back to its 2007 level. It shouldn’t have because 2007 wasn’t a steady state. In terms of policy implications, this means that monetary policy arguably is not an especially effective tool for strengthening the labor market. Instead, I believe you need to focus on retraining workers or investing in skills in some form. You might also want to look at disability and some other government programs that might act as a drag on unemployment.\”

Union membership varies wildly across high-income countries. In addition, there is a phenomenon of \”collective bargaining coverage,\” often not familiar to American readers, which measures the share of workers who are covered by collective bargaining agreement, even though they are not union members. In the US, union density is almost the same as collective bargaining coverage. But in France, only 7.7% of workers are actual union members while 98% of workers are covered by collective bargaining agreements. Here are some facts on these patterns across high-income countries from the OECD publication called Economic Policy Reforms 2016: Going for Growth.

As a starter, here are figures showing the variation in the share of workers who are covered by a collective bargaining agreement (Panel A) and the share actually belonging to a union (Panel B). Just glancing at the figure should offer two lessons: 1) There\’s a lot of variation across countries; 2) Many of the coverage rate percentages are substantially higher than the union membership percentages; that is, in a lot of countries a large share of workers will find that their compensation is determined by collective bargaining, even though they are not a union member.

Here are some specific examples of the differences between union density and collective bargaining coverage, drawing from the OECD data:

For those who need a dose of economics with their end-of-summer Labor Day family cookout (and really, don\’t we all need that?), here\’s a sampling of some previous posts.

1) Origins of Labor Day (September 7, 2015)

The first Labor Day march and celebration almost didn\’t happen, for lack of a band. Also, was Maguire or McGuire the one who had the idea for such a holiday?

2) Update on US Unions (October 8, 2015)

About 30% of the US workforce belonged to a union back in the early 1950s, compared to barely more than 10% today. Union workers do earn more, but at least in part, this is because their employers how to compete with a mixture of higher-priced labor, fewer jobs, and more capital investment . Are there alternative institutions that might help represent the modern needs of US workers?

3) The Gig Economy and Alternative Jobs

All of the job growth is in \”alternative\” jobs (April 11, 2016), which are in some sense temporary or on-call jobs without the expectation of a lasting attachment to a an employer. The US government is planning an updated survey of how many in the \”gig economy\” (February 16, 2016), because the current studies use different definitions and get different answers. There may be a need for new rules for workers in the gig economy (December 9, 2015).

4) Income Inequality

Here\’s an update on the income share being received by the top 1% in the US economy (July 6, 2016). Here\’s my argument as to why stock options are a primary reason for the growth of compensation and income inequality at the top of the income distribution (March 25, 2016).  One occasionally hears the argument that greater inequality may lead to slower economic growth, but I\’m skeptical  (May 29, 2015).

5) Unemployment is Bottoming Out, So What\’s Next? (January 26, 2016)

The US unemployment rate has been 5% or lower since October 2015. It\’s unlikely to fall a lot further. So are we beginning to see the next steps in a healthy labor market, like wage increases and a rise in labor market participation rates?

This week before Labor Day, news about economics tends to be scarce, while academics and teachers are looking ahead to the next term. In that spirit, I\’m going to pass along some thoughts about teaching this week.

With the 2016 election season in full force, here\’s a timeless thought from Max Weber in his 1918 lecture, \”Science as a Vocation\” (available various place on the web, like here and here).

“The primary task of a useful teacher is to teach his students to recognize \’inconvenient\’ facts–I mean facts that are inconvenient for their party opinions. And for every party opinion there are facts that are extremely inconvenient, for my own opinion no less than for others. I believe the teacher accomplishes more than a mere intellectual task if he compels his audience to accustom itself to the existence of such facts. I would be so immodest as even to apply the expression \’moral achievement,\’ though perhaps this may sound too grandiose for something that should go without saying.”

This week before Labor Day, news about economics tends to be scarce, while academics and teachers are looking ahead to the next term. In that spirit, I\’m going to pass along some thoughts about teaching this week.

It sometimes seems to me that too much of education is about asking students whether they understand or don\’t understand, or whether they agree or disagree, both of which can be useful steps, but neither of which pushes a student to interrogate their own understanding more closely. Here\’s a comment from Harry Berger, a professor of literature and art history, that captures some of my concern on this point:

“The first and most important move every young citizen of the interpretive community should make is to perform the pledge of allegiance to interpretation, and I don’t think it’s a bad idea for students to learn a little piety with the move. So I urge all teachers everywhere to insist that their students begin every day by murmuring in unison, and with expression, dutifully and even prayerfully, the two parts of the primal invocation that will prepare all American children to question both church and state:

Let there be at least one unacceptable interpretation of any text.
Let there be at least two acceptable interpretations of any text.

This little pair of exhortations seems innocuous, but taken together and perused more closely they open up a space between dogmatism and indeterminacy; they establish textual boundaries that can be policed.”

The quotation is from from Berger\’s 2005 book Situated utterances: texts, bodies, and cultural representations (Fordham University Press, p. 494).

This week before Labor Day, news about economics tends to be scarce, while academics and teachers are looking ahead to the next term. In that spirit, I\’m going to pass along some thoughts about teaching this week.

In the last year or two, many campuses and classroom have seen arguments that seemed to pit robust debate against \”safe spaces.\” I liked what Roxane Gay, a professor of English at Purdue University, had to say on this subject in a piece written for the New York Times last fall called “The Seduction of Safety, on Campus and Beyond” (November 13, 2015).

I like the definitiveness of Gay\’s statements that students will be challenged but won\’t be tormented, and the emphasis that a good class is built on trust.

This week before Labor Day, news about economics tends to be scarce, while academics and teachers are looking ahead to the next term. In that spirit, I\’m going to pass along some thoughts about teaching this week.

Like every teacher, I suppose, I\’ve had more than one talk with a student who said: \”I understand it all just fine in my mind, or when you say it or I read the textbook, but when I try to write it down, I just can\’t seem to say what I mean.\” One semester I had heard this line often enough that I posted on my door this rejoinder from Montaigne\’s essay \”On the Education of Children, written around 1579-1580.

This week before Labor Day, news about economics tends to be scarce, while academics and teachers are looking ahead to the next term. In that spirit, I\’m going to pass along some thoughts about teaching this week. Let\’s start with some characteristically realistic (or even cynical?) comments from Adam Smith in the Wealth of Nations, from his discussion \”Of the Expense of Institutions for the Education of Youth\” (Book V, Ch. 1, Part III, Art. II).

Smith argues that when teachers don\’t have incentives to work on their teaching, then teachers will either \”neglect it altogether, or … perform it in as careless and slovenly a manner as that authority will permit.\” Moveover, if all the teachers come together in a college or university, they will support each other in their disdain for teaching: \”In the university of Oxford, the greater part of the public professors have, for these many years, given up altogether even the pretence of teaching.\” Smith further argues that all the discipline at colleges and universities is aimed at students, not teachers, and includes this comment: \”Where the masters, however, really perform their duty, there are no examples, I believe, that the greater part of the students ever neglect theirs. No discipline is ever requisite to force attendance upon lectures which are really worth the attending, as is well known wherever any such lectures are given.\”

Here are the extended passages from which these snippets are drawn:

\”In other universities the teacher is prohibited from receiving any honorary or fee from his pupils, and his salary constitutes the whole of the revenue which he derives from his office. His interest is, in this case, set as directly in opposition to his duty as it is possible to set it. It is the interest of every many to live as much as his ease as he can; and if his emoluments are to be precisely the same, whether he does, or does not perform some very laborious duty, it is certainly his interest, at least as interest is vulgarly understood, either to neglect it altogether, or, if he is subject to some authority which will not suffer him to do this, to perform it in as careless and slovenly a manner as that authority will permit. If he is naturally active and a lover of labour, it is his interest to employ that activity in any way, from which he can derive some advantage, rather than in the performance of his duty, from which he can derive none.

\”If the authority to which he is subject resides in the body corporate, the college, or university, of which he himself is a member, and in which the greater part of the other members are, like himself persons who either are, or ought to be teachers; they are likely to make a common cause, to be all very indulgent to one another, and every may to consent that his neighbour may neglect his duty, provided he himself is allowed to neglect his own. In the university of Oxford, the greater part of the public professors have, for these many years, given up altogether even the pretence of teaching. …

\”The discipline of colleges and universities is in general contrived, not for the benefit of the students, but for the interest, or more properly speaking, for the ease of the masters. Its object is, in all cases, to maintain the authority of the master, and whether he neglects or performs his duty, to oblige the students in all cases to behave to him as if he performed it with the greatest diligence and ability. It seems to presume perfect wisdom and virtue in the one order, and the greatest weakness and folly in the other. Where the masters, however, really perform their duty, there are no examples, I believe, that the greater part of the students ever neglect theirs. No discipline is ever requisite to force attendance upon lectures which are really worth the attending, as is well known wherever any such lectures are given.\”

Wealth is not income. Economists sometimes say that \”wealth is a stock, income is a flow.\” They mean that wealth is accumulated over time, and includes assets and debts. Income is what flows in during a give period of time, often measured during a week or a year. The most prominent data source for estimates of US family wealth is the Survey of Consumer Finance, conducted once every three years by the Federal Reserve. Data from the 2013 survey is the most recent available, and the the Congressional Budget Office has released a short report made up of figures and short commentaries showing Trends in Family Wealth, 1989-2013. Here are some snapshots:

The overall wealth of US families totalled about $67 trillion in 2013. As the figure shows, this total has more-or-less doubled since about 1995. Most of increase is attributable to a rising total for the top 10%, which means that the wealth distribution is clearly becoming more unequal over time.

Of course, no one should expect the distribution of wealth to be anything near equal. For example, those who are in their 60s, relatively near the end of their work life, really should have more in retirement accounts and home equity than, say, those in their early 20s–who may well have negative wealth due to student loans. Here\’s a breakdown of patterns in average wealth per family, divided up by age. I suspect that the reason that average wealth for the age 50-64 group climbed so rapidly during the early 2000s and then plunged during the recession has to do with this group being more affected by the rise and then the fall of real estate prices and the stock market. As one would expect, the average family in the under-35 age group has little wealth.

A related factor will be education level, given that education is positively correlated both with higher incomes from year to year (and thus a higher ability to save) and also with a greater ability to plan for the future. Here\’s the breakdown of wealth per family by education level.

In other words, families that have graduate degrees and are over 65 have seen a sharp rise in wealth. Families that are under-35 and with lower levels of education don\’t tend to have much wealth. This CBO report is really just providing data: it doesn\’t seek to analyze or explain underlying causes. But here\’s a breakdown of family wealth by percentile.

 A family in the 90th percentile of the wealth distribution has seen a significant rise over time, although less than a doubling. A family in the 75th percentile has had a more modest rise since the early 1990s. Family wealth levels at the 50th and 25th percentiles haven\’t changes much in the last 25 years. Given that the rise in total wealth is so much less than a doubling at all of these percentiles, and given that total family wealth doubled from 1995 to 2013, there must be some percentiles where there is more than a doubling. Presumably these are the share of wealth at the very top of the wealth distribution, perhaps the 95th or 99th percentile. At some level, this result is unsurprising. Run-ups in stock prices and housing prices tend to raise the wealth of those who own the most of these assets.

The Federal Reserve reduced what had been its main policy-related interest rate, the federal funds reserve rate, down to a target range of 0% to 0.25% at the tail end of 2008, and kept it there until December 2015, when it raised the target range to 0.25% to 0.5%. With this interest rate essentially stuck in place for nearly eight years and still at near-zero levels, what should come next?

The status quo plan seems to call for the Fed to carry out slow and intermittent policy of raising the federal funds rate back to more usual levels over time. But there are two diametrically opposite proposals in the wind, both of them counterintuitive in some ways. One proposal is for the Fed to push its policy interest rate into negative territory. The other \”neo-Fisher\” proposal is for the Fed to raise interest rates as a tool that seeks to raise inflation. Both proposals have enough uncertainties that that I suspect the Fed will continue along its present path. But here\’s an overview of the two alternative approaches.

Benoît Cœuré, a member of the Executive Board of the European Central Bank, provided a useful overview \”Assessing the implications of negative interest rates,\” in a July 28, 2016 lecture. Perhaps the first mental hurdle to cross in thinking about negative interest rates is to remember that they are already happening, which does not prove whether they are wise or unwise, but certainly proves that they are not impossible! As he points out, the European Central Bank pushed a key policy interest rate into negative territory in June 2014. The Swiss National Bank went negative in December 2014. The Bank of Japan went negative in January 2016.

In some broader sense, it is of course true that financial markets have been accustomed to the idea of negative real interest rates for quite some time After all, back in the 1970s when inflation rose unexpectedly, lots of institutions found that their earlier loans were being repaid with inflated dollars–in effect, real interest rates turned out to be negative. Anyone investing in long-term bonds when the nominal interest rate is positive, but very low, needs to face the very real chance that if inflation rises, the real interest rate will turn out to be negative. If you take checking account fees into account, lots of people have had negative real interest rates on their checking accounts for a long time.

Cœuré offers a figure on government bond yields in different countries (which is not the same as the policy interest rate set by a central bank, but what investors are receiving when they buy a bond), at different maturities. Government bond yields are negative for bonds with shorter-term maturities in a number of countries, although not in the US or the UK.

As I see it, the events that led to negative policy interest rates can be expressed using the basic relationship named after the great long-ago economist Irving Fisher (1867-1947). Fisher pointed out that:

nominal interest rates = real interest rates plus inflation.

Thus, back in the mid-1990s, it was common for US government borrowing to pay a nominal interest rate of about 6% on a 10-year government bond, which one could think of as about 3-4% a real interest rate on a safe asset, and 2-3% the result of inflation. In the last 15 years or so, real interest rates have been driven ever-lower by global macroeconomic forces involving demographics, rates of saving and investment, rising inequality, an increased desire for ultra-safe assets, and other forces. (For a discussion, see this post on \”Will the Causes of Falling Interest Rates Unwind?\” from February 25, 2016).  Inflation rates have of course been very low in the last few years as well, especially since the Great Recession and the sluggish recovery that followed.

When real interest rates and inflation are both very low, nominal interest rates will also be low. Thus, when a central bank wants to cut interest rates, it will very quickly reach an interest rate of 0%–and need to start thinking about the possibility of negative rates.

But although negative interest rates are now real, and not hypothetical, just how much they can accomplish remains unclear. After all, it seems unlikely that the reasons for a lack of lending and borrowing–whatever they are–will be profoundly affected by having the central bank policy interest rate shift from barely above 0% to barely below 0%. Thus, the question becomes whether to push the negative interest rates lower still. Cœuré discusses possible tradeoffs here.

For example, one issue is whether economic actors start holding large amounts of cash, which at least pays a 0% interest rate, to avoid the negative rates. At least at the current levels of negative interest rates, this hasn\’t happened. As noted already, actual real interest rates have often been negative in the past. Although Cœuré doesn\’t discuss this point in any detail, there\’s some survey evidence that people (and firms) may react to negative interest rate by saving more and having a bigger cash cushion, which would tend to work against such low rates stimulating borrowing and spending.

Instead, Cœuré focuses on the issue of whether there is what he calls an \”economic lower bound,\” where the potentially positive effects of negative interest rates in encouraging banks to lend are offset by potentially negative effects. He looks at evidence on the sources of profits for euro-area banks, and finds: \”In recent years, the distribution of these sources has been fairly stable, with approximately 60% of income coming from net interest income, 25% from fees and commissions and 15% from other income sources.\”

\”Net interest income\” basically means that a bank lends money out at an interest rate of, say, 3%, but then pays depositors an interest rate of, say, 1%–and thus earns revenue from the gap between the two. But as interest rates fall in general and in some cases go negative, the interest rate that banks can charge borrowers is dropping, but banks don\’t feel that they can pay negative interest rates to their depositors, so those interest rates–already near-zero–can\’t fall. Thus, the main source of bank revenues, net interest income, is squeezed. On the other side, the lower and negative interest rates also benefit banks in some ways, both on their balance sheets, and also because if the economy is stimulated, banks will face fewer bad loans. But as these processes unfold, the banking sector can be shaken up. Cœuré writes:

Indeed, analysts forecast a decline in bank profitability in 2016 and 2017, mainly due to lower net interest income. And the recent decline in euro area bank share prices can be at least partially ascribed to market concerns over future banks profitability. … As such, if very low or negative rates are here for a prolonged period of time due to the structural drivers highlighted above, banks might have to rethink their business models. The revenue structure of euro area banks was stable for a long time but it has recently begun to change and there is at least some evidence of banks tending to offer fee-based products to clients as substitutes for interest-based products.

The overall irony here is that there has been enormous concern in recent years over the risks of an unhealthy banking industry, and a common recommendation has been to require banks to build up their capital, so that they won\’t be as vulnerable to economic downturns and won\’t need payouts. But when a central bank uses a negative policy interest rate, it is saying that banks will not be receiving interest on a certain subset of their funds, but instead will be paying out money on a certain subset of their funds. When higher-ups at the European Central Bank start talking about how all the euro-area banks \”might have to rethink their business models,\” that\’s not a small statement. For some more technical research on how to think about when harms to the banking sector might outweigh other benefits, a useful starting point is a working paper by Markus K. Brunnermeier and Yann Koby, “The “Reversal Rate”: Effective Lower Bound on Monetary Policy,” presented at a Bank of International Settlements meeting on March 14, 2016.

There are other uncertainties about very low and negative-yield interest rates. If a government decides that it wants to borrow heavily for a fiscal stimulus, does this at some point become difficult to do if the government is offering very low or negative interest rates? Certain policy steps might make sense for a smaller economy like Switzerland, where the central bank is in part using the policy interest rate to affect its exchange rate, but might not make sense for the mammoth US economy. The Fed has no desire to risk setting off off a pattern of central banks around the world competing to offer ever-more-negative interest rates. Taking all this together, I expect that while negative policy interest rates will continue in Europe for some time, concerns about financial sector stability and other issues means that they are unlikely to be adopted by the US Federal Reserve. Fed vice-chair Stanley Fischer made a quick and dismissive  reference to negative interest rates in a talk on the broader economy last week, saying that \”negative interest rates\” were \”something that the Fed has no plans to introduce.\” Of course, \”has no plans\” doesn\’t mean \”will never do it,\” but the current policy of the Fed calls for a slow rise its policy interest rate, not decline.

For a full-scale tutorial on the state of thinking about central banking and negative interest rates, a useful starting point is at June 6 symposium on \”Negative Interest Rates: Lessons Learned … So Far,\” which was held by the Hutchins Center on Fiscal and Monetary Policy at Brookings. The weblink has full video for about three hours of the session, together with a transcript and slides from the speakers.

The polar opposite to negative interest rates is the idea of raising interest rates as a way of increasing inflation, a set of arguments which is considerably more counterintuitive than the case for negative interest rates. Stephen Williamson provides a readable overview of these arguments in \”Neo-Fisherism: A Radical Idea, or the Most Obvious Solution to the Low-Inflation Problem?\” which appears in the July 2016 issue of The Regional Economist, published by the Federal Reserve Bank of St. Louis (pp. 4-9 offers a primer for understanding the neo-Fisherian argument. Again, neo-Fisherian refers to the relationship invoked by the famous economist between nominal interest rates and inflation:

nominal interest rates = real interest rate + rate of inflation.

This relationship isn\’t mysterious. When anyone lends or borrows, they pay attention to the expected rate of inflation. Lots of people took out home mortgages at 12% and more back in the early 1980s, because inflation had recently been 10% and higher, so they expected to be able to pay off the mortgage in inflated dollars. In modern times, of course, it would seem crazy to borrow money at a 12% interest rate, given that inflation is down in the 1-2% range.

When the Federal Reserve raises the nominal interest rate, what does the Fisher relationship suggest could happen? One theoretical possibility is that the rate of inflation changes to match the change in the nominal interest rate. This theoretical possibility, called the \”neutrality\” of money, suggests that the Fed can raise or lower nominal interest rates all it wants, but there won\’t be any actual effect on real interest rates. However, the evidence suggests that monetary policy isn\’t completely neutral. Instead, if the Fed changes interest rates, then the real rate of interest also changes for a time, which is why monetary policy can affect the real economy. But if the real interest rate is ultimately determined as a market price in the global economy, then any change due to the central bank will be short-run, and the real interest rate will eventually return to its equilibrium level.

Based on this idea, here\’s a figure from Williamson to describe the theory of neo-Fisherism. On the far left, the red line shows the real interest rate, the green line shows the rate of inflation, and if you add these together you get the blue line that shows the nominal interest rate. At time T, the Fed raises the nominal interest rate. Because of the nonneutrality of money, the real interest rate r shown by the red line rises, too. But over time, the real interest rate is then pushed by underlying market forces back to its original equilibrium level. However, if the Fisher relationship must hold true, then the drop in the real interest rate must be matched by a rise in the inflation rate shown by the green line. (Those who want a more detailed mathematical/theoretical presentation  of these arguments might  begin with John Cochrane\’s Hoover Institution working paper from February 2016, \”Do Higher Interest Rates Raise or Lower Inflation?\”)

Neo-Fisherism offers a possible explanation of how some central banks around the world ended up in their current situation. The Fed cut interest rates, because it sought to stimulate the economy and avoid deflation. But by cutting interest rates, the Fed according to neo-Fisherism instead brought on lower inflation. The Bank of Japan has had rock-bottom interest rates for years, and negative interest rates recently, while inflation has stayed rock-bottom and even occasional deflation has occurred. Rock-bottom and even negative interest rates don\’t seem to have caused inflation in Europe, either.  Williamson refers to this outcome as the \”low inflation policy trap.\”

However, neo-Fisherism also raises some obvious questions: Why are we trying to achieve a goal of higher inflation? Doesn\’t that jolt of rising real interest rates in the short-term risk causing a recession?

On the issue of inflation, there has long been a concern that deflation is a legitimate cause for worry. After all, deflation means that everyone who has borrowed money at a fixed interest rate in the past would now be facing a higher real interest rate. On the other side, a few percentage points of inflation would mean that everyone who borrowed at fixed interest rates in the past would be able to repay in inflated dollars, thus, reducing the burden of their debts. In addition, very low inflation combined with what have now become very low real interest rates means that the Fed can\’t react to a recession by cutting nominal interest rates–at least not without entering the swamp of negative interest rates. Williamson describes the arguments this way:

\”There are no good reasons to think that, for example, 0 percent inflation is worse than 2 percent inflation, as long as inflation remains predictable. But \”permazero\” damages the hard-won credibility of central banks if they claim to be able to produce 2 percent inflation consistently, yet fail to do so. As well, a central bank stuck in a low-inflation policy trap with a zero nominal interest rate has no tools to use, other than unconventional ones, if a recession unfolds. In such circumstances, a central bank that is concerned with stabilization—in the case of the Fed, concerned with fulfilling its \”maximum employment\” mandate—cannot cut interest rates. And we know that a central bank stuck in a low-inflation trap and wedded to conventional wisdom resorts to unconventional monetary policies, which are potentially ineffective and still poorly understood.\”

What about the risk that a spike in real interest rats could bring financial disruptions and even a recession? Williamson\’s essay doesn\’t discuss the possibility. Perhaps if the Fed described what it was going to do, and why it was going to do it, the spike in real interest rates might be smaller. But the risks of neo-Fisherism seem like a real danger to me. Among other changes, neo-Fisherism would be a very dramatic change in Fed policy, and for that reason alone it has the potential to be highly destabilizing at least in the short run.

So if the Federal Reserve is trapped between not wanting to go with negative interest rates on one hand, but also not believing in neo-Fisherism on the other hand as a justification for a dramatic rise in interest rates, what does it do. For some context, consider the unemployment rate (blue line) and inflation rate (red line) in the last few years. Unemployment has been drifting lower. The inflation rate was up around 2% in early 2014, but then dropped down to near-zero, in part as a result of the sharp fall in oil prices during that time. After that fall in oil prices was completed, inflation went back up to about 1% by late 2015. Not coincidentally, the Fed also raised its target for the federal funds interest rate in December 2015. The Fed is taking a wait-and-see stance, but my guess is that if inflation goes up to the range of about 2%, the Fed will view this as an opportunity to raise its nominal interest rate target a little higher. That is, instead of the neo-Fisherism view in which raisint the nominal interest rate brings on higher inflation, the Fed is instead letting inflation go first, and raising the interest rates afterward.

Essentially, the Fed is trying to creep back to a range in which nominal interest rates are closer to the historical range. But if real interest rates remain low, because of various evolutions in the global economy, then nominal interest rates can only be higher if the inflation rate rises by a few percentage points.