Suppose your house needs a new roof, and the interest rate on the loan you require to get the work done is extraordinarily low -- but expected to rise in the future. In addition, construction work has been slow in the area, meaning labor and other costs are at bargain rates for the time being. Should you get the work done now or wait until later when it might cost quite a bit more?
That's the situation the U.S. now faces over infrastructure spending. The nation has considerable needs for bolstering its infrastructure, interest rates remain ultralow but are expected to rise in the future, and the costs for labor and raw materials are below normal due to the slow recovery from the Great Recession but are likely to increase over time.
Why wait to do the work?
The case is even more compelling for two additional reasons. First, investment in infrastructure can improve productive capacity and increase America's economic growth rate, which has been slow in recent years due to falling productivity. But investment in infrastructure could help reverse this trend.
Second, wages have been stagnant, and labor markets haven't yet fully recovered from the recession. Government spending on infrastructure will put people to work, and as labor markets begin to tighten it will put upward pressure on wages.
However, as University of Rochester professor and former President of the Federal Reserve Bank of Minneapolis Narayana Kocherlakota points out, the impact that infrastructure spending has on economic growth and employment depends critically on how the Federal Reserve responds:
"Suppose, for example, the government increased infrastructure spending greatly," wrote Kocherlakota. "If the Fed were to raise interest rates, it would constrain the growth of household consumption and business investment. By tightening sufficiently, the Fed could essentially eliminate the effects of any stimulus program on aggregate output. All that would happen is that the composition of aggregate activity would swing away from private expenditures toward public expenditures."
Why would the Fed respond to government spending on infrastructure by raising interest rates? Fear of inflation.
Monetary policy doesn't affect the economy immediately because of long lags between a change in monetary policy and its impact on output and inflation. Given these lags, the Fed must forecast where the economy will be six months to a year ahead, and then set its target interest rate based on this forecast.
If the economy is relatively close to full employment presently, as the Fed seems to believe, then government spending could overheat the economy and create inflationary pressure. To prevent this, the Fed would increase interest rates to offset the impact of the infrastructure spending.
But what if the Fed is wrong? The recent debate over University of Massachusetts professor Gerald Friedman's assertion that Bernie Sanders' economic plan could increase economic growth by as much as 5.3 percent over the next eight years is in large part a debate about how close we are to full employment.
This debate has revealed considerable disagreement among economists about the country's capacity for growth over the next few years. Kocherlakota, for example, argues that "with appropriate stimulus, it would be possible to achieve growth outcomes of around 5-6% per year for the next four years."
Who is correct?
It's impossible to say. Estimates of the nation's productive capacity are inherently noisy, and it's possible to find reasons to support both views of how much room there is for growth over the next several years.
What we can do is assess the cost of each type of mistake -- assuming there's little room for expansion when actually quite a bit exists as opposed to assuming lots of room for growth when it's not there -- and use that as a guide for monetary and fiscal policy.
The cost of the first mistake -- assuming the economy's ability to grow is more limited than it actually is and raising interest rates in response to infrastructure spending -- would result in less employment than we could have had. Joblessness is very costly for the people it affects and for the nation as a whole. Households hit by unemployment have difficulty paying their bills. Their savings are wiped out, making them less secure in retirement, less able to weather a rainy day and less able to send their kids to college.
They're in danger of losing their homes, marriages can be affected and all sorts of personal costs are likely in addition to the economic burden that unemployment imposes on households. It could lead the nation as a whole to produce less goods and services, collect less tax revenue and add pressure on social programs that the unemployed rely upon.
It's an error we ought to avoid if we can.
The cost of the other mistake -- assuming there's considerable room for growth when such room is actually limited -- would be inflation. Rising prices have costs, for example, by tending to transfer income from lenders to borrowers. But the Fed can reverse inflation, and the costs fall mainly on those at the higher end of the income distribution. This is a much less damaging error.
To me, the conclusion is clear. America needs to begin rebuilding its infrastructure now, not later, and we need to continue investing in it until we see that inflation is a problem. At that point, the Fed can raise interest rates to control the inflationary pressure, and that will allow continued investments in infrastructure until the country's many needs are met.
Our house needs a new roof, workers are ready and the longer we wait to fix it, the more costly it will be.