Answering the Hardest Question in Economics

Xavier Gabaix, a New York University economist who gets far less attention than he should, has written what might prove to be the most interesting macroeconomic theory paper in years. The title, “A Behavioral New Keynesian Model,” isn't exactly exciting and the paper is still incomplete, but it might help resolve the most important and difficult macroeconomic debate in academia today -- whether low interest rates cause inflation, deflation or neither. And it might signal a sea change in the way macroeconomic theory gets done.

Traditionally, macroeconomists have believed that low interest rates encourage inflation. But first Japan, and now the U.S. and Europe have kept rates low for years now, and inflation has stayed stubbornly low. A radical group of macroeconomists, including Stephen Williamson of the Federal Reserve Bank of St. Louis and John Cochrane of the Hoover Institution, have introduced a new theory called Neo-Fisherism, which says that a long period of low interest rates actually holds prices down instead of pushing them up. Williamson and Cochrane have both repeatedly stressed that New Keynesian models -- the most mainstream type of macroeconomic theory -- can easily yield the Neo-Fisherian result instead of the traditional view. One problem is that the standard models are often ambiguous -- they offer a number of possible, radically different outcomes for the economy, with no way to tell which will happen.