The PPP Journal - Issue 75
A spending solution?
19 December 2011
Public investment in infrastructure will be a politically driven burden for taxpayers, argues Dr Richard Wellings, Deputy Editorial Director of the Institute of Economic Affairs
As the economic slump persists, calls are growing for an increase in infrastructure spending as a means of boosting growth. Both David Cameron and Nick Clegg have announced plans for the delivery of planned schemes to be speeded up in order to bring forward the alleged benefits.
In theory, investment in infrastructure has tremendous potential to promote recovery. Improved transport links can reduce journey times and deliver significant productivity gains. Businesses can pass on their savings to customers in the form of lower prices, which in turn boost demand for their products and services. Transport investment can also increase productivity by lowering the costs of trade, which in turn promotes competition and specialisation, as well as facilitating greater economies of scale.
Energy investment can be similarly beneficial. Lower energy bills reduce business costs and increase productivity by enabling greater use of labour-saving technology. The released labour can then be put to other productive uses.
The policy of increasing infrastructure spending during a slowdown is therefore very appealing; however, there is one major problem: politics.
Politicians and senior government officials have very poor incentives to invest efficiently. Instead, they are likely to allocate resources in order to boost their own positions. Politicians may seek to satisfy special interest groups and increase their chances of re-election; senior officials may seek to enhance their power and status by consolidating their department's influence over policy. In addition, ideological considerations – such as a focus on 'fairness' or the environment – may trump economics when it comes to investment decisions.
A further problem is the loading of financial risks onto taxpayers. Politicians and bureaucrats may be less concerned than private investors about making bad investments that lead to huge losses.
The history of infrastructure spending bears out these concerns. A high proportion of investment has been directed towards loss-making projects that have failed to make anything close to a commercial return. Worse still, many schemes have required ongoing operating subsidies to keep them going. Capital expenditure has been written off.
Recent examples of loss-making projects include the tram schemes constructed in several major UK cities over the last two decades, the Channel Tunnel Rail Link (High Speed 1) and the upgrade of the West Coast Main Line. In today's money, the total cost of these schemes is in the order of £25bn.
Part of the problem is that politicians seem to favour high status 'big projects' over smaller schemes that offer much better value for money for taxpayers. The government is now supporting big and expensive rail projects, such as Crossrail (£17bn) and High Speed 2 (HS2, £34bn). Both of these schemes are likely to be loss-making. Taxpayers, not commercial investors, are funding their construction. Realistic projections of passenger numbers also suggest that fares will struggle to cover operating costs, meaning taxpayers will face an ongoing subsidy burden for decades to come.
It is important to point out that such investment decisions are essentially political in nature. According to the government's own cost-benefit analyses, there are a very large number of transport schemes with far higher returns than Crossrail and HS2. Some, such as the Heathrow expansion, would have been entirely privately funded. Yet most of these initiatives will never be undertaken. Scarce resources will instead be devoted to wasteful high-profile vanity projects.
However, there is an argument that when it comes to promoting recovery, long-term returns are perhaps less important than boosting short-term demand in the economy. Keynesian economists argue that increasing public spending can create a positive multiplier by utilising idle resources. For example, if unemployed people are given jobs, they then have more money to spend on goods and services.
There are, however, several reasons why stimulus policies are unlikely to succeed in achieving a sustainable recovery.
Firstly, public spending absorbs resources that would otherwise be available to the private sector – a process known as 'crowding out'. Private sector investment will tend to decline as the role of the government expands.
Secondly, stimulus policies inevitably involve higher levels of government borrowing. Increased public debt puts upward pressure on interest rates, raising the cost of loans for private investment. It also raises expectations that taxes will rise in the future to pay off the debt, which in turn reduces investors' confidence in the long-run performance of the economy.
Finally, public spending creates vested interests that depend on continued government support. After the recession is over, it becomes difficult for politicians to withdraw subsidies for activities initiated during the stimulus programme. The role of the state may increase permanently as a result of policies undertaken during slumps, with highly negative long-term economic effects resulting from a higher tax burden and less economic freedom.
Historical evidence appears to support critics of stimulus policies. For example, many commentators now view Roosevelt's New Deal as a failure in terms of promoting recovery from the Great Depression. Wasteful spending on new roads, dams and irrigation projects arguably 'crowded out' private sector investment on more productive enterprises. Indeed, the US went back into recession in the late 1930s – in 1938, for example, living standards were lower than they had been 15 years earlier in 1923.
More recently, infrastructure spending spearheaded efforts by the Japanese government to lift the country out of prolonged stagnation. Once again, the economic record suggests that this was unsuccessful. Worse still, the ill-fated stimulus programme has left Japan with a national debt at over 200% of GDP – higher than Greece and Italy.
So even if stimulus spending were somehow allocated efficiently, there would still be major downsides. In reality, there is little reason to expect that the UK government will invest any more successfully than other governments. Indeed, recent evidence suggests that infrastructure investment will be wasteful, politically driven and will incur losses that burden taxpayers for decades to come.