Escaping the Liquidity Trap By Increasing Interest Rates

In the white paper, The Making of a Great Contraction with a Liquidity Trap and a Jobless Recovery, Stephanie Schmitt-Grohé and Martin Uríbe, economics professors at Columbia University, conclude:

The great contraction of 2008 pushed the U.S. economy into a protracted liquidity trap (i.e., a long period with zero nominal interest rates and inflationary expectations below target). In addition, the recovery was jobless (i.e., output growth recovered but unemployment lingered). This paper presents a model that captures these three facts. The key elements of the model are downward nominal wage rigidity, a Taylor-type interest-rate feedback rule, the zero bound on nominal rates, and a confidence shock. Lack-of-confidence shocks play a central role in generating jobless recoveries, for fundamental shocks, such as disturbances to the natural rate, are shown to generate recessions featuring recoveries with job growth. The paper considers a monetary policy that can lift the economy out of the slump. Specifically, it shows that raising the nominal interest rate to its intended target for an extended period of time, rather than exacerbating the recession as conventional wisdom would have it, can boost inflationary expectations and thereby foster employment.
 
…The rationale for this strategy is the recognition that in a confidence-shock induced liquidity trap the effects of an increase in the nominal interest rate are quite different from what conventional wisdom would dictate. In particular, unlike what happens in normal times, in an expectations driven liquidity trap the nominal interest rate moves in tandem with expected inflation. Therefore, in the liquidity trap an increase in the nominal interest rate is essentially a signal of higher future inflation. In turn, by its effect on real wages, future inflation stimulates employment, thereby lifting the economy out of the slump.

But does this finding make sense in the real world?  In The Bond Beat, Steve Feiss wrote:

TWO THOUGHTS … BEFORE WE GET CARRIED AWAY WITH THIS ONE …
 
FIRST, think about housing and ask IF there will be enough (or more) good as folks jump OFF fence and race to lock in low rates/buy homes because of fear of higher rates?? OR will higher rates simply RETARD an already investor-led and meager housing recovery?
 
SECOND, think about the impact of higher rates as it relates TO the United States of America’s DEBT BURDEN … Pick a percentage you’d like and can defend but one thing is clear. USAs debt/GDP ratio is no longer an asset but rather a liability. Reinhardt and Rogoff have written extensively on topic and we are all now experts on concept that a high and rising debt/gdp burden becomes a GOVERNOR ON FUTURE ECON GROWTH … ? Playing mind games with our globally interdependent system seems almost childish.
 
Our push-back is just as the authors might suspect it would be (with reference to ‘conventional wisdom’) … perhaps our glasses are a bit rose-colored. Maybe we’re just too simplistic.

Sources:
The Making of a Great Contraction with a Liquidity Trap and a Jobless Recovery,
Stephanie Schmitt-Grohé and Martin Uríbe
National Bureau of Economic Research Working Paper 18544
November 2012
 
The Bond Beat
Steven J. Feiss
Government Perspectives, LLC
November 20, 2012