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Central Banking’s Bankrupt Narrative

The combination of low unemployment and stubbornly low inflation across Western advanced economies has exposed the fundamental flaws of the standard economic theory that have long informed monetary policymaking. What theory should replace it?

LOS ANGELES – Former US Secretary of the Treasury Lawrence H. Summers and Anna Stansbury recently cast doubt on the future of central banking, suggesting that the prevailing monetary-policy framework is in dire need of a rethink. I agree, and have been calling for a reconsideration of “Old Keynesian economics” for more than a decade, starting with an article I published in 2006, two years before the Great Recession made it fashionable to question the way we think about macroeconomic theory. I am heartened that the narrative and body of research I have developed continues to gain public support.

In the current era of low – and in some cases negative – interest rates, many are starting to worry that the European Central Bank and the US Federal Reserve are “running out of ammunition.” When a central bank’s policy rate is already low, it cannot be lowered much more in the event of a crisis. Hence, one could argue that the Fed actually should be raising rates now, while unemployment is low, to create enough space for interest-rate cuts in the future, when unemployment may be high. Yet it makes no sense to raise interest rates if doing so could trigger a recession. The question, then, is whether there is a way to restock the powder keg without generating an explosion.

When the Fed or the ECB raises rates, New Keynesian economic theory predicts that the hike will eventually lead to a decrease in inflation, and that the path from point A to point B will inevitably be accompanied by higher unemployment. But my own research suggests that New Keynesian economic theory is wrong. After all, if the Fed were to raise the short-term rate slowly and support equity markets with a guarantee to purchase a broad-based exchange-traded fund at a fixed price, there is no reason why the rate increase should cause higher unemployment.