Many politicians throughout the world,
not just on the centre and left, are arguing for increased spending on infrastructure. This was one of the key proposals of Donald Trump during his election campaign. In his election manifesto he pledged to “Transform America’s crumbling infrastructure into a golden opportunity for accelerated economic growth and more rapid productivity gains”.
Increased spending on inffrastructure has both demand- and supply-side effects.
Unless matched by cuts elsewhere, such spending will increase aggregate demand and could have a high multiplier effect if most of the inputs are domestic. Also there could be accelerator effects as the projects may stimulate private investment.
On the supply side, well-targeted infrastructure spending can directly increase productivity and cut costs of logistics and communications.
The combination of the demand- and supply-side effects could increase both potential and actual output and reduce unemployment.
So, if infrastructure projects can have such beneficial effects, why are politicians often so reluctant to give them the go-ahead?
Part of the problem is one of timing. The costs occur in the short run. These include demolition, construction and disruption. The direct benefits occur in the longer term, once the project is complete. And for complex projects this may be many years hence. It is true that demand-side benefits start to occur once construction has begun, but these benefits are widely dispersed and not easy to identify directly with the project.
Then there is the problem of externalities. The external costs of projects may include environmental costs and costs to local residents. This can lead to protests, public hearings and the need for detailed cost–benefit analysis. This can delay or even prevent projects from occurring.
The external benefits are to non-users of the project, such as a new bridge or bypass reducing congestion for users of existing routes. These make the private construction of many projects unprofitable, except with public subsidies or with public–private partnerships. So there does need to be a macroeconomic policy that favours publicly-funded infrastructure projects.
One type of investment that is less disruptive and can have shorter-term benefits is maintenance investment. Maintenance expenditure can avoid much more costly rebuilding expenditure later on. But this is often the first type of expenditure to be cut when public-sector budgets as squeezed, whether at the local or national level.
The problem of lack of infrastructure investment is very much a political problem. The politicians who give the go-ahead to such projects, such as high-speed rail, come in for criticisms from those bearing the short-run costs but they are gone from office once the benefits start to occur. They get the criticism but not the praise.
Articles
Are big infrastructure projects castles in the air or bridges to nowhere? The Economist, Buttonwood’s notebook (16/1/17)
Trump’s plans to rebuild America are misguided and harmful. This is how we should do it. The Washington Post, Lawrence H. Summers (17/1/17)
Questions
- Identify the types of externality from (a) a new high-speed rail line, (b) new hospitals.
- How is discounting relevant to decisions about public-sector projects?
- Why are governments often unwilling to undertake (a) new infrastructure projects, (b) maintenance projects?
- Is a programme of infrastructure investment necessarily a Keynesian policy?
- What accelerator effects would you expect from infrastructure investment?
- Explain the difference between the ‘spill-out’ and ‘pull-in’ effects of different types of public investments in a specific location. Is it possible for a project to have both effects?
- What answer would you give to the teacher who asked the following question of US Treasury Secretary, Larry Summers? “The paint is chipping off the walls of this school, not off the walls at McDonald’s or the movie theatre. So why should the kids believe this society thinks their education is the most important thing?”
- What is the ‘bridge to nowhere’ problem? Why does it occur and what are the solutions to it?
- Why is the ‘castles in the air’ element of private projects during a boom an example of the fallacy of composition?
We’ve considered Keynesian economics and policy in several blogs. For example, a year ago in the post, What would Keynes say?, we looked at two articles arguing for Keynesian expansionary polices. More recently, in the blogs, End of the era of liquidity traps? and A risky dose of Keynesianism at the heart of Trumponomics, we looked at whether Donald Trump’s proposed policies are more Keynesian than his predecessor’s and at the opportunities and risks of such policies.
The article below, Larry Elliott updates the story by asking what Keynes would recommend today if he were alive. It also links to two other articles which add to the story.
Elliott asks his imaginary Keynes, for his analysis of the financial crisis of 2008 and of what has happened since. Keynes, he argues, would explain the crisis in terms of excessive borrowing, both private and public, and asset price bubbles. The bubbles then burst and people cut back on spending to claw down their debts.
Keynes, says Elliott, would approve of the initial response to the crisis: expansionary monetary policy (both lower interest rates and then quantitative easing) backed up by expansionary fiscal policy in 2009. But expansionary fiscal policies were short lived. Instead, austerity fiscal policies were adopted in an attempt to reduce public-sector deficits and, ultimately, public-sector debt. This slowed down the recovery and meant that much of the monetary expansion went into inflating the prices of assets, such as housing and shares, rather than in financing higher investment.
He also asks his imaginary Keynes what he’d recommend as the way forward today. Keynes outlines three alternatives to the current austerity policies, each involving expansionary fiscal policy:
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Trump’s policies of tax cuts combined with some increase in infrastructure spending. The problems with this are that there would be too little of the public infrastructure spending that the US economy needs and that the stimulus would be poorly focused. |
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Government taking advantage of exceptionally low interest rates to borrow to invest in infrastructure. “Governments could do this without alarming the markets, Keynes says, if they followed his teachings and borrowed solely to invest.” |
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Use money created through quantitative easing to finance public-sector investment in infrastructure and housing. “Building homes with QE makes sense; inflating house prices with QE does not.” (See the blogs, A flawed model of monetary policy and Global warning). |
Increased government spending on infrastructure has been recommended by international organisations, such as the OECD and the IMF (see OECD goes public and The world economic outlook – as seen by the IMF). With the rise in populism and worries about low economic growth throughout much of the developed world, perhaps Keynesian fiscal policy will become more popular with governments.
Article
Keynesian economics: is it time for the theory to rise from the dead?, The Guardian, Larry Elliott (11/12/16)
Questions
- What are the main factors determining a country’s long-term rate of economic growth?
- What are the benefits and limitations of using fiscal policy to raise global economic growth?
- What are the benefits and limitations of using new money created by the central bank to fund infrastructure spending?
- Draw an AD/AS diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on GDP and prices.
- Draw a Keynesian 45° line diagram to illustrate the effect of a successful programme of public-sector infrastructure projects on actual and potential GDP.
- Why might an individual country benefit more from a co-ordinated expansionary fiscal policy of all countries rather than being the only country to pursue such a policy?
- Compare the relative effectiveness of increased government investment in infrastructure and tax cuts as alterative forms of expansionary fiscal policy.
- What determines the size of the multiplier effect of such policies?
- What supply-side policies could the government adopt to back up monetary and fiscal policy? Are the there lessons here from the Japanese government’s ‘three arrows’?
In his 2016 Autumn Statement, the new Chancellor of the Exchequer, Philip Hammond, announced that he was abandoning his predecessor’s target of achieving a budget surplus in 2019/20 and beyond. This was partly in recognition that tax revenues were likely to be down as economic growth forecasts were downgraded by the Office for Budget Responsibility. But it was partly to give himself more room to boost the economy in response to lower economic growth. In other words, he was moving from a strictly rules-based fiscal policy to one that is more interventionist.
Although he still has the broad target of reducing government borrowing over the longer term, this new flexibility allowed him to announce increased government spending on infrastructure.
The new approach is outlined in the updated version of the Charter for Budget
Responsibility, published alongside the Autumn Statement. The government’s fiscal mandate would now include the following:
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a target to reduce cyclically-adjusted public-sector net borrowing to below 2% of GDP by 2020/21; |
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a target for public-sector net debt as a percentage of GDP to be falling in 2020/21. |
It also states that:
In the event of a significant negative shock to the UK economy, the Treasury will review the appropriateness of the fiscal mandate and supplementary targets as a means of returning the public finances to balance as early as possible in the next Parliament.
In the Autumn Statement, the new approach to fiscal policy is summarised as follows:
This new fiscal framework ensures the public finances continue on the path to sustainability, while providing the flexibility needed to support the economy in the near term.
With his new found freedom, the Chancellor was able to announce spending increases, despite deteriorating public finances, of £36bn by 2021/22 (see Table 1 in the Autumn Statement).
Most of the additional expenditure will be on infrastructure. To facilitate this, the government will set up a new National Productivity Investment Fund (NPIF) 
to channel government spending to various infrastructure projects in the fields of housing, transport, telecoms and research and development. The NPIF will provide £23bn to such projects between 2017/18 and 2021/22.
But much of the additional flexibility in the new Fiscal Mandate will be to allow automatic fiscal stabilisers to operate. The OBR forecasts an increase in borrowing of £122bn over the 2017/18 to 2021/22 period compared with its forecasts made in March this year. Apart from the additional £23bn spending on infrastructure, most of the rest will be as a result of lower tax receipts from lower economic growth. This, in turn, is forecast to be the result of lower investment caused by Brexit uncertainties and lower real consumer spending because of the fall in the pound and the consequent rise in prices.
But rather than having to tighten fiscal policy to meet the previous borrowing target, the new Fiscal Mandate will permit this rise in borrowing. The lower tax payments will help to reduce the dampening effect on the economy.
So are we entering a new era of fiscal policy? Is the government now using discretionary fiscal policy to boost aggregate demand, while also attempting to increase productivity? Or is the relaxation of the Fiscal Mandate just a redrawing of the rules to give a bit more flexibility over the level of stimulus the government can give the economy?
Videos
Autumn Statement 2016: Philip Hammond’s speech (in full) GOV.UK (23/11/16)
Philip Hammond’s autumn statement – video highlights The Guardian (23/11/16)
Key points from the chancellor’s first Autumn Statement BBC News, Andrew Neil (23/11/16)
Autumn Statement: higher borrowing, lower growth Channel 4 News, Helia Ebrahimi (23/11/16)
Autumn Statement: Chancellor’s growth and borrowing figures BBC News (23/11/16)
Markets react to Autumn Statement Financial Times on YouTube, Roger Blitz (23/11/16)
Hammond’s Autumn Statement unpicked Financial Times on YouTube, Gemma Tetlow (23/11/16)
Autumn Statement 2016: The charts that show the cost of Brexit Sjy News, Ed Conway (24/11/16)
BBC economics editor Kamal Ahmed on the Autumn Statement. BBC News (23/11/16)
Autumn statement: debate Channel 4 News, Financial Secretary to the Treasury, Jane Ellison, and Labour’s Shadow Business Secretary, Clive Lewis (23/11/16)
Autumn Statement: Workers’ pay growth prospects dreadful, says IFS BBC News, Kevin Peachey and Paul Johnson (24/11/16)
Articles
Autumn Statement 2016: Expert comment on fiscal policy Grant Thornton, Adam Jackson (23/11/16)
Philip Hammond loosens George Osborne’s fiscal rules to give himself more elbow room as Brexit unfolds CityA.M., Jasper Jolly (23/11/16)
Britain’s New Fiscal Mandate Opens Way To Invest For Economic Growth Forbes, Linda Yueh (23/11/16)
Autumn Statement 2016: experts respond The Conversation (23/11/16)
Chancellor’s ‘Reset’ Leaves UK Economy Exposed And Vulnerable Huffington Post, Alfie Stirling (23/11/16)
Britain’s Autumn Statement hints at how painful Brexit is going to be The Economist (26/11/16)
Chancellor’s looser finance targets highlight weaker UK economy The Guardian, Phillip Inman (24/11/16)
Hammond’s less-than-meets-the-eye plan that hints at the future Financial Times, Martin Sandbu (23/11/16)
Economists’ views on Philip Hammond’s debut Financial Times, Paul Johnson, Bronwyn Curtis and Gerard Lyons (24/11/16)
Government Publications
Autumn Statement 2016 HM Treasury (23/11/16)
Charter for Budget Responsibility: autumn 2016 update HM Treasury
Reports, forecasts and analysis
Economic and fiscal outlook – November 2016 Office for Budget Responsibility (23/11/16)
Autumn Statement 2016 analysis Institute for Fiscal Studies (November 2016)
Questions
- Distinguish between discretionary fiscal policy and rules-based fiscal policy.
- Why have forecasts of the public finances worsened since last March?
- What is meant by automatic fiscal stabilisers? How do they work when the economic growth slows?
- What determines the size of the multiplier from public-sector infrastructure projects?
- What dangers are there in relaxing the borrowing rules in the Fiscal Mandate?
- Examine the arguments for relaxing the borrowing rules more than they have been?
- If the economy slows more than has been forecast and public-sector borrowing rises faster, does the Chancellor have any more discretion in giving a further fiscal boost to the economy?
- Does the adjustment of borrowing targets as the economic situation changes make such a policy a discretionary one rather than a rules-based one?
The first article below, from The Economist, examines likely macroeconomic policy under Donald Trump. He has stated that he plans to cut taxes, including reducing the top rates of income tax and reducing taxes on corporate income and capital gains. At the same time he has pledged to increase infrastructure spending.
This expansionary fiscal policy is unlikely to be accompanied by accommodating monetary policy. Interest rates would therefore rise to tackle the inflationary pressures from the fiscal policy. One effect of this would be to drive up the dollar and therein lies significant risks.
The first is that the value of dollar-denominated debt would rise in foreign currency terms, thereby making it difficult for countries with high levels of dollar debt to service those debts, possibly leading to default and resulting international instability. At the same time, a rising dollar may encourage capital 
flight from weaker countries to the US (see The Economist article, ‘Emerging markets: Reversal of fortune’).
The second risk is that a rising dollar would worsen the US balance of trade account as US exports became less competitive and imports became more so. This may encourage Donald Trump to impose tariffs on various imports – something alluded to in campaign speeches. But, as we saw in the blog, Trump and Trade, “With complex modern supply chains, many products use components and services, such as design and logistics, from many different countries. Imposing restrictions on imports may lead to damage to products which are seen as US products”.
The third risk is that the main beneficiaries of Trump’s likely fiscal measures will be the rich, who would end up paying significantly less tax. With all the concerns from poor Americans, including people who voted for Trump, about growing inequality, measures that increase this inequality are unlikely to prove popular.
Articles
That Eighties show The Economist, Free Exchange (19/11/16)
The unbearable lightness of a stronger dollar Financial Times (18/11/16)
Questions
- What should the Fed’s response be to an expansionary fiscal policy?
- Which is likely to have the larger multiplier effect: (a) tax revenue reductions from cuts in the top rates of income; (b) increased government spending on infrastructure projects? Explain your answer.
- Could Donald Trump’s proposed fiscal policy lead to crowding out? Explain.
- What would protectionist policies do to (a) the US current account and (b) dollar exchange rates?
- Why might trying to protect US industries from imports prove difficult?
- Why might Trump’s proposed fiscal policy lead to capital flight from certain developing countries? Which types of country are most likely to lose from this process?
- Go though each of the three risks referred to in The Economist article and identify things that the US administration could do to mitigate these risks.
- Why may the rise in the US currency since the election be reversed?
In the blog post, Global warning, we looked at the use of unconventional macroeconomic policies to deal with the slow pace of economic growth around the world. One of the articles was by Nouriel Roubini. In the linked article below, he argues that slow economic growth may be the new global norm.
At the centre of the problem is a fall in the rate of potential economic growth. This has been caused by a lack of investment, which has slowed the pace of innovation and the growth in labour productivity.
The lack of investment, in turn, has been caused by a lack of spending by both households and governments. What is the point in investing in new capacity, argue firms, if they already have spare capacity?
Low consumer spending is partly the result of a redistribution of income from low- and middle-income households (who have a high marginal propensity to consume) to high-income households and corporations (who have a low mpc). Low spending is also the result of both consumers and governments attempting to reduce their levels of debt by cutting back spending.
Low growth leads to hysteresis – the process whereby low actual growth leads to low potential growth. The reason is that the unemployed become deskilled and the lack of investment by firms reduces the innovation that is necessary to embed new technologies.
Read Roubini’s analysis and consider the policy implications.
Article
Has the global economic growth malaise become the ‘new normal’? The Guardian, Nouriel Roubini (2/5/16)
Questions
- Explain what is meant by ‘hysteresis’ and how the concept is relevant in explaining low global economic growth.
- Why has there been a reduction in the marginal propensity to consume in recent years? What is the implication of this for the multiplier and economic recovery?
- Explain what Roubini means by ‘a painful de-leveraging process’. What are the implications of this process?
- How important are structural reforms and what forms could these take? Why has there been a reluctance for governments to institute such reforms?
- ‘Asymmetric adjustment between debtor and creditor economies has also undermined growth.’ Explain what Roubini means by this.
- Why are governments reluctant to use fiscal policy to boost both actual and potential economic growth?
- What feasible policy measures could be taken to boost actual and potential economic growth?
