Scott Sumner  

Krugman's confusing argument for more infrastructure spending

PRINT
Kleiman on Trade and Taxes... Libertarianism Against the Wel...

Paul Krugman says that there are three reasons to support more infrastructure spending. But he actually only provides two. The problematic reason is:

The second case is a bit, but only a bit, harder: we are still in or near a liquidity trap, a situation in which cutting interest rates as far as possible isn't enough to restore full employment.
I'd guess that seems plausible to most readers, as Krugman has been advocating fiscal stimulus for years, and always citing the liquidity trap as the justification. But in fact it's anything but clear, as Krugman himself surely knows. Krugman has consistently argued that fiscal stimulus is only justified at the zero rate bound. The fact that rates are even a tiny bit above zero completely invalidates the argument for fiscal stimulus.

Krugman confuses the issue by pointing to the fact that when rates are close to zero, the central bank might not be able to cut them enough to provide adequate stimulus for the economy. I think that's wrong, but it doesn't really matter what I think, because even if it is 100% correct, it has absolutely no bearing on the argument for fiscal stimulus right now, as Krugman surely understands. After all, if fiscal stimulus was enacted then the Fed would not be trying to cut rates, they'd raise them further in order to slow inflation. If interest rates are even one basis point above rock bottom (and who knows where rock bottom is these days, but it's certainly no higher than zero) then the Fed will offset any fiscal stimulus. The only possible growth effects would then come from the supply-side effects of the stimulus---theoretically possible, but exceedingly unlikely.

You might wonder how I can be so sure that Krugman understands the weakness of his argument. Am I accusing him of being intentionally misleading? No, I'm no mind-reader. But I am able to read the "small print" he adds later, perhaps anticipating this criticism:

You might ask, but are we still in that condition, given that the Fed has started to raise rates? Well, it shouldn't have -- it shouldn't be raising rates until it sees the whites of inflation's eyes. And it would take only a modest shock to push us well into negative-natural-rate territory again. Put it this way: the asymmetric-risks story many of us have been using to argue against rate hikes is also a reason to consider increased public investment a valuable insurance policy, giving the economy headroom that might turn out to be crucial if anything goes wrong.
So it actually won't help the economy, at least not with a 4.9% unemployment rate and a Fed bound and determined to raise interest rates. So how does Krugman react to this inconvenient truth? He basically says the Fed should not be raising rates. In other words, if the Fed was doing what it should, we'd be at the zero bound, and then fiscal stimulus might work. And if I had wings . . .

He also talks about an "insurance policy". Perhaps we will again slip into recession, in which case rates would fall back to zero and fiscal stimulus might be useful.

But elsewhere he undercuts the argument for fiscal stimulus right now:

What this means, in turn, is an extended period during which conventional monetary policy can't restore full employment; and while unconventional monetary policy can and should be tried,one thing that we know works is increased public spending. So there's an overwhelming case for a burst of spending while we're in the trap. That spending can be withdrawn later on without hurting employment, because once you're out of the liquidity trap the Fed can offset the contractionary effects of a fiscal tightening by holding off on the monetary tightening it would otherwise have pursued.

This is why Keynes declared that "The boom, not the slump, is the right time for austerity."


Krugman's right that fiscal stimulus is most effective (if at all, which I doubt) if it's used counter-cyclically. You can't run big budget deficits from now until the end of time. The national debt may never be repaid, but it must at least be serviced. So you want to do stimulus during periods of high unemployment and austerity during periods of low unemployment. The unemployment rate is now 4.9%, and falling. The only thing keeping the unemployment rate from falling even faster is the Fed's anti-inflation policy, which is expected to lead to further rate increases going forward. To say this is not the optimal time for fiscal stimulus is an understatement. It's getting close to the worst possible time. Indeed by the time "shovel ready" infrastructure projects are ready to go, it might well be the worst possible time.

In the end, Krugman has one good argument for infrastructure---we need it. But let's not mix in bad Keynesian arguments; even the Keynesian model says this is a horrible time for fiscal stimulus.


Comments and Sharing






COMMENTS (18 to date)
S.C. Schwarz writes:

Isn't the federal deficit for 2016 projected to exceed $600 billion? Isn't that a huge deficit by historical standards? Didn't federal spending under Obama increase from some $3 trillion to about $4 trillion, an enormous increase in such a short time? In other words, didn't we already do what Krugman says we should do and got stagnation anyway?

William writes:

Prof. Sumner,

I think monetary offset is getting more and more traction, but liquidity trap stories seem to be never going away — at least abroad. Look at this article discussing Japan from FT http://www.ft.com/intl/cms/s/0/fe6740a4-e079-11e5-9217-6ae3733a2cd1.html#axzz4240k9wNi

Do you think negative IOR are proving to be ineffective? It looks like such an awkward "unconventional tool" for a central bank.

Alexander Hudson writes:

When I read Krugman's post, I more-or-less glossed over the stimulus argument, for the reasons cited here.

Having said that, I think his "asymmetric risk" argument does make some sense. Even if the ZLB shouldn't in principle pose a problem for monetary policy, in reality it does. The Fed acts as though there's an enormous cost to having rates at zero for such a long time, and that getting to nonzero rates is itself a desirable thing, independent of what inflation and employment are doing. I think this psychology is a big reason the Fed raised rates last year. By no means was it the ONLY reason, but I do think it was a big reason. (Certainly I think it's hard to argue that high inflation is the primary constraint on monetary policy right now.) As a result of this "low interest rates are inherently bad" mentality, the Fed is less likely to respond to a disinflationary shock than an inflationary shock when the economy is near the ZLB. The asymmetry should be more pronounced the closer we are to the ZLB, since a given shock is more likely to push the economy to the ZLB. The economy need not be precisely at the ZLB for the ZLB to be a problem.

Infrastructure spending should raise the natural interest rate, moving the economy further away from the ZLB and allowing the Fed to make policy decisions strictly on the basis of the balance between unemployment and inflation, rather than on some arbitrary desire for higher interest rates. That is, more government spending should lead to a more symmetric Fed response. In most scenarios, this wouldn't lead to higher nominal growth (the multiplier would be roughly zero), but the scenarios where nominal growth slows (possibly leading to recession) would be less likely.

Of course, with low rates likely to persist for some time, this argument suggests that government spending should be semi-permanently higher. Which I suppose appeals to Krugman, who wants more government spending anyway. Others might have a problem with that. In any case, the ideal solution to the Fed's asymmetric policy is to switch to a different policy regime. This solution is also probably easier to achieve, since it doesn't involve convincing a Republican-dominated Congress to significantly increase government spending.

ThomasH writes:

I think it is a mistake to call spending that meets an NPV test "fiscal stimulus." On the other hand, I do not think we can be so sure that the Fed will persist in its mistaken policy of trying to reduce (future) inflation in the face of fiscal spending that meets the NPV rule. After all it will create future AS making the Fed's efforts to reduce future inflation easier.

Don Geddis writes:

@Alexander Hudson: This no longer seems to be an argument about economics. You're essentially saying that the Fed is incompetent (which may be true), and you're trying to propose non-Fed policies which might trick the Fed into accidentally behaving more competently.

That's a fine approach, but there may be lots of (non-economic) options to force a more competent Fed response. How about advocating for the entire Fed governing board to resign, and replace them with more competent macroeconomists? Maybe physically threaten the individuals, or blackmail them, or bribe them? Send cocaine and hookers over to each governor's house. Might that also result in "a more symmetric Fed response"?

It seems odd, if you agree that the Fed is implementing substandard policy, that your preferred solution is to compensate elsewhere in the economy in order to attempt to trick the Fed into acting better. Why not just go to the source, shine the spotlight on the Fed itself, and get it to implement better monetary policy?

Scott Sumner writes:

S.C. He would say they didn't do enough.

William, Whether a given tool is effective depends how it is used.

Alexander, You said:

"The Fed acts as though there's an enormous cost to having rates at zero for such a long time, and that getting to nonzero rates is itself a desirable thing, independent of what inflation and employment are doing. I think this psychology is a big reason the Fed raised rates last year."

This is actually an argument for not raising rates in December. If the risks are asymmetric then faster NGDP growth would reduce the risk of recession, by raising the trend interest rate.

As far as higher infrastructure spending---the Japanese tried that and it did not lead to higher nominal interest rates. If you want higher nominal rates, you need a higher NGDP target path.

You said:

"Of course, with low rates likely to persist for some time, this argument suggests that government spending should be semi-permanently higher."

Why not taxes semi-permanently lower?

Thomas, So you agree with my view that infrastructure spending should meet the NPV test? Isn't that more likely to occur if the private sector builds the infrastructure, rather than the government? Should we privatize JFK airport?

Alexander Hudson writes:

@Don: I never said more infrastructure spending was my preferred solution to substandard Fed policy. I was just trying to make sense of Krugman's asymmetry argument, which I don't find compelling (since I don't share his skepticism of the efficacy of monetary policy near the ZLB), but which I also don't find confusing. In fact, I agree 100% with everything you say, right down to the blackmail. I thought I covered my bases at the end of my comment when I said, "the ideal solution to the Fed's asymmetric policy is to switch to a different policy regime." Apparently not. Sorry for being confusing.

Alexander Hudson writes:

Scott,

You said: "This is actually an argument for not raising rates in December."

I think what you're saying is that if the Fed doesn't like having low rates, then they need to generate higher NGDP growth, which requires lower rates in the short term. If that's what you're saying, I agree, but I'm not sure everyone at the Fed understands this.

You said: "As far as higher infrastructure spending---the Japanese tried that and it did not lead to higher nominal interest rates. If you want higher nominal rates, you need a higher NGDP target path."

I'm not sure I like the Japan comparison here, because I don't think the Fed's response function is the same as the BOJ's. For all the talk about Japan's difficulty in generating inflation, and the supposed failure of quantitative easing in Japan, I thought the BOJ before Abe had a pretty clear goal of 0% inflation. Under those circumstances (an inflation-targeting central bank that is successfully hitting its target), we wouldn't expect fiscal stimulus (in whatever form it takes) to raise NGDP growth. Fiscal stimulus and fiscal austerity are both neutralized because they take the central bank away from its target.

I don't see today's Fed in the same way. I view them as having a floor (about 1%) and a ceiling (about 2%) for inflation. If rates were higher (like they were in the mid-2000's), I think they'd stay closer to the ceiling. But if rates are low (as they are now), I think they're willing to let inflation drift downward somewhat, especially if preventing it requires doing unconventional things like QE, which they view (rightly or wrongly) as having costs.

Under these circumstances, I do think an infrastructure spending program would keep the Fed closer to its ceiling. But like I said in my response to Don's comment above, I don't find it to be a compelling argument for infrastructure spending, because there are better, more direct ways of addressing the Fed's incompetence. And unless the infrastructure package was huge, it probably wouldn't raise NGDP growth all that much, so the benefit on that front is small.

You said: "Why not taxes semi-permanently lower?"

Sure.

Anand writes:

Scott,
I have made this point before, but since you keep making this point, I feel compelled to do this as well. Krugman is assuming a different counterfactual than you.

"He basically says the Fed should not be raising rates. In other words, if the Fed was doing what it should, we'd be at the zero bound, and then fiscal stimulus might work. And if I had wings"

Suppose there was a fiscal stimulus. In the absence of monetary offset, it would be an increase in AD. Krugman says that he thinks that there should not be rate hikes, and fiscal stimulus should be made in conjunction with such a policy. He would of course not support a policy of fiscal stimulus and monetary contraction.

Suppose AD increases and there is no increase in inflation (which seems likely). How likely is it that the Fed will raise rates as a monetary offset in this scenario?

Anand writes:

The previous post should say: "inflation below 2.0 percent" instead of "no increase in inflation"

ThomasH writes:

Scott,

Of course there are many kinds of infrastructure (and other presently government functions) that can be privatized; my favorite is the airport security industry now run by TSA. But to work properly, in a countercyclical sense those private projects would need access to essentially government finance rates. The Fed gets around it's fear of QE by buying lots of federally guaranteed infrastructure debt. Whether the political economy of public guarantees of private infrastructure will get us higher NPV's is anybody's guess.

Peter Gordon writes:

Job #1 must be to find a way to screen for pork projects. Why the same old song and dance -- and then look the other way as bullet trains are sold?

Scott Sumner writes:

Alexander, You said:

"If that's what you're saying, I agree, but I'm not sure everyone at the Fed understands this."

Then God help us, because that's undergraduate economics.

On the rest, I would just reiterate that if we plan to go the fiscal route, I'd prefer lower taxes. And I still don't see why Japan's zero inflation target would hold down REAL interest rates while they had the big infrastructure push.

Anand, You said:

"He would of course not support a policy of fiscal stimulus and monetary contraction."

But that's exactly my point. He'd only support fiscal stimulus when it would not face monetary offset, and hence he does not support fiscal stimulus right now.

You asked:

"Suppose AD increases and there is no increase in inflation (which seems likely). How likely is it that the Fed will raise rates as a monetary offset in this scenario?"

Extremely likely. As we saw in December, the Fed's dual mandate causes them to raise rates when AD rises (and unemployment falls), even if there is no rise in inflation.

Travis allison writes:

I think pk's point is that if the govt spends and the fed raises rates that gives additional room off of zero for the fed to cut rates later should we go into a recession.

Of course the costs of this policy aren't considered.

Alexander Hudson writes:

"Then God help us, because that's undergraduate economics."

Isn't that sort of the point? That we've been making undergrad level mistakes since 2008? Reasoning from a price change, reviving fallacies explicitly debunked in Mishkin's textbook (at least the earlier versions), etc. Outside of blogs like this one, much of the debate over monetary policy has made very little sense.

"And I still don't see why Japan's zero inflation target would hold down REAL interest rates while they had the big infrastructure push."

My argument is not that the BOJ's policy held down real interest rates, but that it kept AD/NGDP precisely along its preferred path. Because of this, it's not surprising that their huge deficits never raised NGDP. My point is that I don't think the Fed has a precisely defined path for NGDP in mind. I think they're comfortable with a range of growth rates (probably 3-5% per year). If that's correct, then fiscal stimulus could, in principle, keep the Fed along the upper end of that range.

Of course, I'm happy to admit that my characterization of the Fed's policy is open to debate. You could argue that the Fed does have a precise preference for the path of NGDP, pointing to the steady 3% growth since the end of the recession. I don't agree with that (I think it's a bit of a coincidence that NGDP has grown steadily since 2009), but the fact that we don't know for sure is an indictment of the Fed's communication strategy. The reality is that we just don't know what the Fed's response function is, so we don't know whether fiscal stimulus would work.

Mr. Econotarian writes:

Krugman says "The first case is simply that America has an obvious infrastructure deficit"

I throw up a little whenever someone talks about "infrastructure". Infrastructure is not a thing. Roads are a thing. Power lines are a thing. Train systems are a thing. Airports are a thing. Multifamily residential housing is a thing.

Each one of these needs to be evaluated on its own cost/benefit ratio. Let us know precisely what kind of "infrastructure" you want to build, and how you will get around local NIMBY regulations.

There are some arguments about US roads and bridges lacking maintenance. Maybe, but I can't think of a single time that a bad road or bridge has affected my commerce. On the other hand, in some African countries, there simply is not a paved road between producers and consumers, and in that case the road situation is dire.

Maybe we need some more power lines to enable diverse power production (such as solar and wind), but power line construction is more limited by NIMBYism than lack of government spending.

But I can tell you one clear "infrastructure deficit", it is the lack of high density housing in major urban areas, which drives up rents and commute times.

If localities eliminated regulation holding back urban housing construction, there would be a huge expansion in economic activity.

And if Krugman really thinks we need a dollar drop from a helicopter, the Federal government could do a mild subsidy (say 2.5% of building costs) on all new construction that adds new housing units beyond what was originally present.

And we can get together with the "greens" so that the new 1000 foot urban housing towers in San Francisco and LA must have a small amount of green park space around them.

So count me in for "tall, affordable, green, safer (seismically)" urban multifamily residential housing infrastructure development!

Scott Sumner writes:

Travis, Maybe, but the case of Japan suggests that's very unlikely to be true.

Alexander, You said:

"My point is that I don't think the Fed has a precisely defined path for NGDP in mind. I think they're comfortable with a range of growth rates (probably 3-5% per year). If that's correct, then fiscal stimulus could, in principle, keep the Fed along the upper end of that range."

Even if there is a range, it's not obvious to me why fiscal stimulus would cause the Fed to want to be near the top of that range.

Good point about all the basic errors made since 2008, but still, I think they know enough to avoid that one.

Mr. Econotarian, Excellent comment. Lots of good points.

Jose Romeu Robazzi writes:

History shows that most Keynesians argue in favor of counter-cyclical fiscal stimuli, but when the economy recovers and comes the time to reduce the deficit (or run surpluses), they back down and continue to favor deficit spending.

Comments for this entry have been closed
Return to top