Scott Sumner  

Janet Yellen confirms much of what I've been saying about fiscal stimulus

Repealing Regulations... Larry Summers's Perspective...

I've been frequently arguing that fiscal stimulus makes no sense, especially at a time when the unemployment rate is 4.9% and the Fed is raising interest rates. Any impact on aggregate demand will be offset by tighter monetary policy.

In contrast, prior to 2007, no one (AFAIK) was suggesting that infrastructure spending is a sensible countercyclical tool when unemployment is 4.9%. And if someone did recommend it, they almost certainly recommended LOWER than usual spending at 4.9% unemployment.
Now Janet Yellen is saying much the same thing; now's not the time for fiscal stimulus:
President-elect Donald Trump has pledged a $1 trillion infrastructure spending program to help jump-start an economy that he said during the campaign was in terrible shape.

Speaking on Capitol Hill Thursday, Federal Reserve Board Chair Janet Yellen warned lawmakers that as they consider such spending, they should keep an eye on the national debt. Yellen also said that while the economy needed a big boost with fiscal stimulus after the financial crisis, that's not the case now.

"The economy is operating relatively close to full employment at this point," she said, "so in contrast to where the economy was after the financial crisis when a large demand boost was needed to lower unemployment, we're no longer in that state."

In my recent Lake Wobegon post I pointed out that fiscal policy can't always be above average. Thus if you do fiscal stimulus when unemployment is relatively low, then in the next recession fiscal policy will have to be tighter than otherwise:

The key point to understand about fiscal stimulus is that more fiscal stimulus today implies less fiscal stimulus during the next recession. That's because the expansionary impact of fiscal stimulus (in the Keynesian model) occurs because the full employment budget deficit gets larger than before, not because it is large in absolute value.

For the moment, let's assume that the full employment deficit during the next recession is $X. In that case, the larger the fiscal stimulus between now and the onset of the next recession, the smaller the increase in the deficit during the next recession, and thus the smaller the fiscal stimulus during the next recession.

And now Janet Yellen is saying the same thing:

Yellen cautioned lawmakers that if they spend a lot on infrastructure and run up the debt, and then down the road the economy gets into trouble, "there is not a lot of fiscal space should a shock to the economy occur, an adverse shock, that should require fiscal stimulus."

In other words, lawmakers should consider keeping their powder dry so they have more options whenever the next economic downturn comes along.

For weeks and months we've been bombarded with nonstop commentary from media "pundits" about how monetary policy is out of ammo, and fiscal stimulus is the shiny new thing that everyone favors. I've been standing in the middle of the road yelling, "stop".

My opponents claimed that the Fed does not agree with me. So how does it feel to achieve a dramatic come from behind fourth quarter victory?

Pretty darn good!

Comments and Sharing

COMMENTS (16 to date)
John Hall writes:

Your analysis is too focused on these two issues. Think about the whole Trump program. Trump's economic policy has basically four planks: cut taxes, increase infrastructure spending, reduce regulations, and increase tariffs. Cutting taxes and increasing infrastructure spending increases aggregate demand and maybe aggregate supply to a lesser extent. Reducing regulations will shift aggregate supply outward. Tariffs shift aggregate demand outward, but also reduce aggregate supply.

I think a good case could be made that the effect of a huge increase in tariffs against China/Mexico would have a bigger impact on aggregate supply in the short-term than aggregate demand. This would mean it has the effect of reducing growth and raising prices. The reduction in regulations could impact aggregate supply, but it couldn't offset the short-term impact of a hike in tariffs. You would need fiscal stimulus to offset the aggregate supply shock from tariffs.

bill writes:

Your analysis is so obviously correct, I find it really disheartening that you have to waste any time on this. I hate writing that.

Thaomas writes:
"fiscal stimulus makes no sense, especially at a time when the unemployment rate is 4.9%"
If you mean by "fiscal stimulus" investment in projects whose NPV is less than zero when discounted by the borrowing rate and whose costs are evaluated at marginal cost rather than market prices, then I agree and the unemployment rate is irrelevant (that goes into the evaluation of the marginal costs of project inputs. But if the projects have positive NPV's then they DO make sense whatever the employment rate, although if and when long term borrowing rates rise there will be fewer such projects.

An interesting case is the value of zero NPV projects which raise the deficit and make it easier for the Fed to meet its price level target, easier because of political constraints on purchases of LT assets (QE). In that circumstance does "fiscal stimulus (=zero NPV projects) make sense or not?

My guess is that there are lots of positive NPV projects out there although whether Mr Trumps economists can find them is more doubtful. Bottom line. Mr Trump's infrastructure investments might or might not make sense.

Scott Sumner writes:

John, Fiscal stimulus does not offset an adverse supply shock; both tend to push inflation above the Fed's 2% target. So fiscal stimulus is not called for even if Trump does the things you suggest he might.

Thanks Bill.

Thaomas, When I say "fiscal stimulus" I mean deficit spending (larger cyclically adjusted deficits), which is the standard definition. This post has nothing to do with "infrastructure".

John Hall writes:

Fiscal stimulus could offset the impact of a supply shock on growth. If Trump doesn't care about higher inflation, then that's sufficient for him.

Brian Donohue writes:

Is it possible that blowing up the deficit increases the likelihood of future inflation because 'debt monetization' increasingly becomes the only way of dealing with the debt?

I do note that real (TIPS) yields also rose on the Trump victory and that the above theory doesn't explain that.

Thaomas writes:

@ John Hall

"Reducing regulations will shift aggregate supply outward"

This depends of course on which regulations. Some have costs greater than their benefits and others have the opposite. Allowing more health-damaging pollution reduces aggregate supply; reducing anti-density land use regulation increases aggregate supply.

Mark Bahner writes:
You would need fiscal stimulus to offset the aggregate supply shock from tariffs.

So to offset the first bad thing, we need to do a second bad thing. Hmmm...what are the words I'm looking for?

"I have a bad feeling about this."
Scott Sumner writes:

John, No it cannot offset the impact on growth, as the Fed won't allow it to.

Brian, Possible, but debt monetization is not on the horizon in the US.

Mark, So do I!

AS writes:

How about zero stimulus and let markets adapt on their own?

ChrisA writes:

To those who suggest that the current interest rates allow more "investment" in infrastructure, please google opportunity cost of capital. What sets the discount rate for a project is not the interest rate that you can borrow at, but the return that you could get elsewhere on the same money. Governments get money from tax payers in other words (eventually) and therefore you have to decide if that money would be better left with the tax payer than invested in infrastructure. Simple googling suggests that around 80% of the US population is in debt, and you can bet they are paying higher interest rates than the US gets on bonds. I highly doubt that there are many projects sitting there unfunded that can get a better return than paying off consumer debt.

Jayson Virissimo writes:

Scott, since you think you could have done better than Bernanke or Yellen, why not prove it? I dare you (for the maximization of utility, of course). You can apply to be part of the Trump administration at

MikeDC writes:

[Comment removed. Please consult our comment policies and check your email for explanation.--Econlib Ed.]

MikeDC writes:

Is Yellen correct now, or a few weeks ago when she was saying the exact opposite?

Back in the glory days of a month ago, she was stumping for fiscal stimulus and in particular infrastructure spending.

Fed pressures Congress to spend

Federal Reserve officials are increasingly making the case that Congress should spend more money to stimulate the economy, with an eye on the infrastructure package that could hit the agenda next year.

Federal Reserve Chairwoman Janet Yellen and Vice Chairman Stanley Fischer have both nudged Congress in recent speeches. They said federal spending that bolsters demand and increases the labor force would take pressure off of monetary policy and help grow the economy.


“There are ways in which the response of fiscal policy to shifts in the economy could be strengthened, which could help take some burden off of monetary policy,” said Yellen in a September press conference.
“Fiscal policy has traditionally played an important role in dealing with severe economic downturns,” said Yellen in an August speech, suggesting work on “improving our educational system and investing more in worker training; promoting capital investment and research spending, both private and public; and looking for ways to reduce regulatory burdens while protecting important economic, financial, and social goals.”
Scott Sumner writes:

MikeDC, Gee, I wonder what's changed from a month ago?

MikeDC writes:


This is why I pointed out Yellen shouldn't be doing this a month ago. As you so often point out, the Fed is in the credibility game. Frittering away that credibility with naked partisanship is bad. For themselves and everyone else.

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