Krugman's confusing argument for more infrastructure spending
By Scott Sumner
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.