Is it time for an infrastructure push?
The International Monetary Fund (IMF) thinks so, and we agree. Public infrastructure investment not only provides a short-term lift to demand; it also helps economies to grow faster without hitting capacity constraints. And to these two benefits, we would add a third: increased infrastructure spending could help relieve the policy burden currently being borne by central banks.
If governments were to do more, monetary policy would no longer have to do quite so much.
Excessive reliance on monetary policy has begun to raise some troubling questions.
Could low interest rates endanger the stability of the banking sector, by putting profitability under pressure? Could further policy loosening be counter-productive, as stressed banks cut back their lending activities? Do ever-increasing waves of quantitative easing (QE) merely boost asset prices, favouring the already wealthy and underpinning the rise in populist political movements in the United States and Europe? And do falling investment returns lead to excessive risk taking, inflating bubbles that could ultimately create economic havoc? If governments were to do more, monetary policy would no longer have to do quite so much.
History suggests that the gains from infrastructure spending can be impressive.
Taking a sample of 17 advanced economies, an increase in investment spending equivalent to 1 percentage point (pp) of national income boosted the level of output by 1.5 pps four years later. So for every pound or dollar a government spends on infrastructure today, it could see a return of £1.50 or $1.50 in the medium term. As a result, the boost to national income a country gets from increasing public infrastructure investment can, if done correctly, pay for itself without adding to the debt burden.
But these figures, while compelling, are just the headlines.
The true benefits of infrastructure spending depend on three factors. First, there is the amount of ‘slack’ in the economy and the behaviour of central banks. Where there is plenty of spare capacity, there is also less risk that extra spending will feed into higher prices. And when monetary policy is in stimulus mode, interest rates are less likely to rise in response to the pick-up in spending. This reduces the risk that public investment merely crowds out private sector activity, leaving the overall economy no better off. Second, there is the efficiency of public investment. The more efficient the process from project identification to delivery, the greater will be the ultimate benefit to the economy. Finally, there is the issue of how the investment is financed. The IMF funds that debt-financed investment has a bigger positive economic impact than investment financed by raising taxes or cutting other forms of spending.
But if infrastructure spending is so great, why haven’t governments acted?
Public investment has actually fallen across the advanced economies, from around 4% of GDP in the 1980s to 3% at present. While some of this decline may reflect an increasing role of the private sector in the provision of infrastructure (such as energy and telecommunications), the level of private investment has also fallen as a share of output over the past three decades.
One fundamental cause lies behind governments’ underwhelming response.
Ultimately, infrastructure projects are often large and capital intensive. Upfront costs are sizeable, but the benefits tend to accrue only over the long term. So where countries’ debt burdens are already high – as many are in the wake of the financial crisis – and the returns to investment drawn out and uncertain, financial markets could take fright. Financing costs could rise, increasing the debt burden and leading to a self-fulfilling vicious cycle. At the same time, concerns about inefficiencies in the public investment process, and the contentious nature of some projects, may stall some much-needed investment before it even gets off the ground.
So where do we go from here?
As concerns about the side-effects of ever-looser monetary policy have grown, so have the demands for greater fiscal activism. Much has been made of moves by a small number of countries (including Japan and China) to ease fiscal policy, and statements of intent by others (including the UK and US) to do more. Whether they will amount to much remains to be seen. But for countries with clear infrastructure needs, efficient public investment processes, spare capacity and accommodative monetary policy, 2017 should be the year of the fiscal boost.
By Lucy O’Carroll, Chief Economist, Aberdeen Solutions. This article originally appeared on the Aberdeen Assest Management’s ‘Thinking Aloud’ blog on 19th October 2016