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Stephanie Schmitt-Grohé started her formal education in Germany. She had enrolled in sinology, chemistry, and economics but soon realized that speaking to important societal problems was her real passion. When she learned that all major economics textbooks were from the U.S., she decided to apply to American universities. Schmitt-Grohé, who received her PhD from the University of Chicago, has been a professor at Columbia University since 2008.

Many economists emphasize that in some cases government intervention is necessary. For example, government can help ensure competition and prevent monopoly, or it can promote a fair distribution of income and wealth. The starting point of Stephanie Schmitt-Grohé’s work is similar. The macroeconomist assumes that market failures occur when setting prices or wages. Interventions of fiscal or monetary authorities can stabilize the economy and support an efficient market outcome.

What can central banks do?

“At the end of the day, you’re trying to say something about policy,” explains Schmitt-Grohé. “Markets by themselves don’t adjust perfectly and prices are, at least in the short run, sticky or rigid. They can’t adjust. We have a model of the market economy where we explicitly allow for this rigidity and think about what the appropriate policy response is when the economy experiences shocks.”

An economic shock Schmitt-Grohé did research on was the financial crisis of 2007-08, when unemployment rates in many European countries skyrocketed. “When you look at Portugal, Spain, Greece, Ireland but also the Baltics, the financial crisis hits and unemployment goes up in all of these countries,” explains Schmitt-Grohé. The economist says that in a world with no market failures, employment would have been more stable because wages would have adjusted to the new economic environment—countries in crisis mood—and gone down. Surprisingly, wages either plateaued or kept rising. “That’s the manifestation of downward nominal wage rigidity,” explains Schmitt-Grohé. “The firm can’t cut the wage, so they say, ‘I let you go.’”

Schmitt-Grohé looked at different policy options to address the unemployment crisis that hit in many countries. Fiscal policy was off the table because the agenda of the time was austerity. “There was fiscal austerity for political reasons, for solvency reasons, for concerns about a debt crisis,” explains Schmitt-Grohé. European governments’ hands were tied, but monetary authorities couldn’t help much either.

“If the country could have devalued their currency, indirectly, they could have made the wage of the worker much lower,” says Schmitt Grohé. “The real wage would have come down. The labor costs would have come down.” Unfortunately, though, devaluation was another tool unavailable because countries were committed to a currency union. “The European countries share the Euro. It’s not that the central bank of Cyprus can change the exchange rate between its currency and the dollar freely. The typical central bank uses the exchange rate as a stabilization instrument. If you join a currency peg, you lose that instrument.”

As an alternative, Schmitt-Grohé analyzed the benefit of imposing capital controls to better regulate capital inflows. “If you look at what happened during the boom phase from 2000 to 2008, the southern periphery of Europe and some of the northern periphery countries borrowed a lot from abroad,” explains Schmitt-Grohé. “Over that period, wages grew even though there was no increase in productivity. It was just because demand was so strong. And why was demand so strong? Because of all this capital coming in. And then you enter the crisis with very high wage levels that you can’t push down.”

According to Schmitt-Grohé, wages wouldn’t have risen that much if less capital would have been allowed to come in during the good times. A moderate wage growth in the boom years would have helped ameliorate the unemployment problem of the subsequent crisis. “It would be taxing capital inflows in good times and subsidizing capital inflows in bad times,” says the economist.

More than ten years after the crisis, Schmitt-Grohé says that some countries have implemented policies to better regulate capital inflows. “In reality, the form it takes is regulations of balance sheets of banks. How much does a bank have to hold in equity for all the loans it makes? In good times, you need to have quite a bit of equity against your loans, and in bad times, you’re allowed to reduce this capital buffer. That’s something we see in banking regulation and that’s very much in the spirit of these countercyclical capital controls.”

The eurozone crisis and currency pegs

Another research area of Schmitt-Grohe is record-low interest rates and low inflation over a long period of time. While too high levels of inflation are undesirable, Schmitt-Grohé explains that moderate inflation is a sign of a healthy economy as it, in multiple dimensions, aids the growth of an economy. Unfortunately, though, many countries have been undershooting their inflation target for years, which may impact the public opinion on central banks’ ability to steer the economy.

“Since the crisis of 2008, central banks haven’t able to reach their inflation target and inflation is low,” says Schmitt-Grohé. “If a central bank keeps saying the inflation target is 2 but they come out short, I think that might over time generate some credibility issues,” says Schmitt-Grohé.

The macroeconomist explains that if interest rates are low and saving rates are high, economies get stuck in a liquidity trap. If interest rates can’t fall any further, a central bank has no tool to stimulate the economy. Monetary policy becomes ineffective.

“In a liquidity trap, monetary policy is constrained. There’s no policy space left,” explains Schmitt-Grohé. “Inflation is below target, and expected inflation, five or ten years out, is also below target.” Schmitt-Grohé says that inflationary expectations are “unanchored.” People don’t believe that the central bank will be able to meet the inflation target anytime soon and take it that the new normal is a world with inflation lower than the central banks’ commitment.

What people expect future inflation to be matters because it affects their decisions. Will a company raise prices? Will a worker try negotiating a better payment? Will a couple decide to buy a house? If people expect future inflation to be low, they might save more than they consume or invest, which, in the end, keeps inflation low.

So what can be done to stimulate inflation?

“We wrote a paper in 2000 motivated by what was going on in Japan that had deflation or inflation below target,” explains Schmitt-Grohé, “We didn’t expect this to become a big topic, and then the 2008 recession came. Since then, many countries have that problem. The euro area, they have interest rates at -0.5 percent. That policy has the explicit objective of bringing inflation back to 2 percent, and nothing is happening.”

According to Schmitt-Grohé, central banks have a chance of reaching moderate inflation by breaking new ground. In an environment with interest rates at zero, they can stimulate inflation by raising interest rates.

“Suppose the ECB said, ‘We should go back to normal and normal is an inflation rate of 2.’ If they start raising interest rates, that will be a way to reanchor inflation expectations,” expects Schmitt-Grohé. “Maybe the way out of this is to go back to interest rates of 3-4 percent, which is normal from a historical point of view.”

“I would love if somebody gave us the opportunity to experiment with this policy,” the economist adds. “Whether a country like Japan, if they go ahead and raise interest rates, can raise inflationary expectations and get out of the liquidity trap. I would love to be given that opportunity.”

Stuck in a liquidity trap

Schmitt-Grohé says that her main source of motivation is addressing policy problems with actual science. “You want to make sure that if you give some policy advice, it’s not just a feeling or an intuition but a formal model,” says the economist. “Economics is a formal field. It tries to speak to very important questions, but it is technology, data, modelling. And let the best model win.”

“Countries can have very different outcomes based on the economic policy they pursue,” underlines Schmitt-Grohé the potential impact of her profession. “It’s not that one country is naturally rich and that’s why the economy is working on favor of their residents. Economics can illuminate how society can be organized in a way that is beneficial, fair and equal.”