Two Columbia University economists think that raising rates is cure for economic slump

As reported by Bloomberg, two Columbia University economists have adopted your humble blogger's suggestion that raising interest rates will help to cure the economic slump.

Regular readers have seen numerous posts over the last couple of years discussing Walter Bagehot and his rule that central banks never lower rates below 2%.

Mr. Bagehot, the father of modern central banking, laid out this rule in the 1870s.  He did this in full knowledge of Mark Twain's famous observation about being more concerned about the return of his capital than the return on his capital.

Mr. Bagehot understood that as rates drop below 2% they create their own economic headwinds including that savers start pursuing Mark Twain's observation.

The solution to weak economic growth may be higher interest rates. 

That seemingly paradoxical remedy can apply if the cause of the slump is a confidence shock that cheap borrowing costs are failing to reverse, two Columbia University economists said in a report published this week. 

In such a situation, ultra-easy monetary policy risks making fears of deflation a self- fulfilling prophecy as spenders sit tight. 

If low interest rates can’t motivate jittery consumers, then the answer may be the opposite: an increase in borrowing costs. Such a shift “can boost inflationary expectations and therefore foster employment,” said Stephanie Schmitt-Grohe and Martin Uribe in the study published Nov. 19 by the National Bureau of Economic Research in Cambridge, Mass.
“By its effect on real wages, future inflation stimulates employment, thereby lifting the economy out of the slump,” they said. 

The academics said sagging confidence among households and companies has played a part in the recent economic slowdown. Evidence from the U.S. as well as Japan during the last two decades “seems to suggest that zero nominal interest rates are not doing much to push inflation higher.”

At the moment, the Federal Reserve pledges to keep its benchmark interest rate near zero through mid-2015.

While I am not an economist, I suspect that the transmission mechanism for economic improvement from higher interest rates is that savers no longer have to offset the lack of return on their savings through more savings, but can instead use this money for consumption.