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When Discredited Policies Make Sense

Narayana Kocherlakota is a Bloomberg View columnist. He is a professor of economics at the University of Rochester and was president of the Federal Reserve Bank of Minneapolis from 2009 to 2015.
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Presidential candidates Donald Trump and Bernie Sanders have proposed policies that run counter to literally centuries of economic thought. In the current environment of extremely low interest rates and low inflation, however, they might make more sense than most economists recognize.

The Federal Reserve faces a big challenge: It wants to get inflation up to its 2-percent target, but so far its stimulus efforts have failed to reach that goal. So there's a good chance it will keep interest rates low, even if inflation pressures pick up a bit. This likely passivity of monetary policy creates a highly unusual situation, in which certain much-discussed economic initiatives could have an unusually positive effect.

Let's consider three ideas that have been popular on the campaign trail.

  • Increasing the minimum wage. What if Congress decided to increase the federal minimum wage by 10 percent a year over the next five years? Typically, economists would be concerned about the impact on employment: Higher wages might lead businesses to employ fewer workers. With monetary policy out of the picture, though, the move might actually help. The expectation of higher wages would cause consumers to expect more inflation over the next few years, leading them to buy more goods and services now, before prices went up. To meet this added demand, businesses would have to boost production and hiring.
  • Increasing import tariffs. Suppose Congress gradually raised tariffs on imported intermediate goods, such as steel and sugar. Economists would worry that this would reduce the benefits of free trade. But as long as the Fed didn’t respond by raising interest rates, there would also be a positive effect: Households would expect higher prices, which would again   prompt them to demand more goods and services today -- creating much-needed demand for businesses.
  • Imposing restrictions on immigration. Most economists would oppose such a move, because immigration is seen as an important contributor to overall growth. Yet again, though, the logic changes somewhat if inflation is too low and the Fed is passive. Households might expect the relative scarcity of labor to drive up wages and prices, triggering purchases that would benefit businesses and the economy more broadly.

The Fed's response is crucial in all these cases. Typically, the central bank reacts to increases in inflation by raising interest rates sharply -- a move that would choke off any demand that the policy measures might generate. With inflation running well below target, however, it’s appropriate for the Fed to hold rates low even if it sees a modest increase in inflationary pressures. It’s this subdued reaction function that allows the policy initiatives to have more positive effects.

To be clear, the policies would have other effects, not all of which would be desirable. My point is simply that passive monetary policy allows for outcomes that are the reverse of observers' (well, at least my) usual intuition. This might help explain why, in the current election campaign, we've seen more support for minimum wage increases, tariff hikes and immigration controls than most economists would expect or prefer.

  1. My arguments in this post build on the research ideas of Professor Gauti Eggertsson of Brown University, as explained in this American Economic Review article.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Narayana Kocherlakota at nkocherlako1@bloomberg.net

To contact the editor responsible for this story:
Mark Whitehouse at mwhitehouse1@bloomberg.net