Over at Equitable Growth: Infrastructure Investment Truly a No-Brainer : Tuesday Focus for October 14, 2014
Over at Equitable Growth: I note the publication of the IMF World Economic Outlook and its chapter 3 calling for North Atlantic economies to borrow more and spend it on infrastructure because, right, now in today's exceptional circumstances, it is--as Larry Summers and I pointed out in 2012--a policy that is self-financing does not increase but rather reduces the relative burden of the national debt.
It is thus time for Larry and me--and everyone else who has been doing the arithmetic--to take a big victory lap.
We have had no effect on policy in the North Atlantic in the past 2 1/2 years. But we were (and are) right. And it is important to register that--both so that our intellectual adversaries rethink their models and thus their positions, and so that the North Atlantic economic policymakers can do better next time. And next time is, come to think of it, right now: interest rates on the debts of reserve currency-issuing sovereigns are no higher, infrastructure gaps are larger, and output gaps are at least as large as they were 2 1/2 years ago. It's not too late to do the right thing, people!
...for countries with infrastructure needs, the combination of low interest rates and mediocre growth mean that it’s time for an investment push. What’s at stake: For countries with infrastructure needs, the combination of low interest rates and mediocre growth mean that it’s time for an investment push. While Brad DeLong and Lawrence Summers already laid out the theoretical case in a 2012 Brookings paper, the empirical case was laid out this week in Chapter 3 of the latest IMF World Economic Outlook.
Lawrence Summers writes that in a time of economic shortfall and inadequate public investment, there is for once a free lunch – a way for governments to strengthen both the economy and their own financial positions. Greg Mankiw writes that the free-lunch view is certainly theoretically possible (just like self-financing tax cuts), but we should be skeptical about whether it can occur in practice (just like self-financing tax cuts).
Abiad and al. write on the IMF blog that the evolution of the stock of public capital suggests rising inadequacies in infrastructure provision. Public capital has declined significantly as a share of output over the past three decades in both advanced and developing countries. In advanced economies, public investment was scaled back from about 4 percent of GDP in the 1980s to 3 percent of GDP at present (maintenance spending has also fallen, especially since the financial crisis).
This makes a very strong case for sharply increasing public investment in a depressed economy
Paul Krugman writes that this is disinvestment madness. Real interest rates are extremely low, indicating that the private sector sees very little opportunity cost in using funds for public investment. There has been a lot of slack in the labor market, so that many of the workers one would employ in public investment would otherwise have been idle--so very little opportunity cost there either. This makes a very strong case for sharply increasing public investment in a depressed economy; a case that doesn’t rely on claims that there is a large multiplier, although there’s every reason to believe that this is also true.
The authors of the WEO’s chapter 3 write that in contrast to the large body of literature that has focused on estimating the long term elasticity of output to public and infrastructure capital using a production function approach, the IMF analysis adopts a novel empirical strategy that allows estimation of both the short- and medium-term effects of public investment on a range of macroeconomic variables. Specifically, it isolates shocks to public investment that can plausibly be deemed exogenous by following the approach of smooth transition VARs of Auerbach and Gorodnichenko (2012, 2013), where the shocks are identified as the difference between forecast and actual investment. In the WEO chapter, the forecasts of investment spending are those reported in the fall issue of the OECD’s Economic Outlook for the same year.
The positive effects of increased public infrastructure investment are particularly strong when public investment is undertaken during periods of economic slack and monetary policy accommodation
The authors of the WEO’s chapter 3 write that a problem in the identification of public investment shocks is that they may be endogenous to output growth surprises. But the public investment innovations identified are only weakly correlated (about –0.11) with output growth surprises. Another possible problem in identifying public investment shocks is a potential systematic bias in the forecasts concerning economic variables other than public investment, with the result that the forecast errors for public investment are correlated with those for other macroeconomic variables. To address this concern, the measure of public investment shocks has been regressed on the forecast errors of other components of government spending, private investment, and private consumption.
Abiad and al. write on the IMF blog that the benefits depend on a number of factors. The authors find that the positive effects of increased public infrastructure investment are particularly strong when public investment is undertaken during periods of economic slack and monetary policy accommodation, where additional public investment spending is not wasted and is allocated to projects with high rates of return and when it is financed by issuing debt has larger output effects than when it is financed by raising taxes or cutting other spending.
Mario Monti writes that while a simplistic stability pact may have been the right choice when the euro was in its infancy, Europe can no longer afford to stick with such a rudimentary instrument. By failing to recognize the proper role of public investment, it has pushed governments to stop building infrastructure just when they should have built more. What is needed is not the flexibility to deviate from the rules, but rules that are economically and morally rigorous. The new Commission should announce a proposal for updating the rules on fiscal discipline, to reflect the role of productive public investment. The commission would then enforce the existing stability pact while allowing for the favorable treatment of public investment within the limits set out in 2013.
Europe needs mechanisms for carrying out self-financing infrastructure projects outside existing budget caps
Lawrence Summers writes that Europe needs mechanisms for carrying out self-financing infrastructure projects outside existing budget caps. This may be possible through the expansion of the European Investment Bank or more use of capital budget concepts in implementing fiscal reviews.
...That is, an IMF study suggests that the expansionary effects are sufficiently large that debt-financed infrastructure spending could reduce the debt-GDP ratio over time. Certainly this outcome is theoretically possible (just like self-financing tax cuts), but you can count me as skeptical about how often it will occur in practice (just like self-financing tax cuts). The human tendency for wishful thinking and the desire to avoid hard tradeoffs are so common that it is dangerous for a prominent institution like the IMF to encourage free-lunch thinking."
The Laffer Curve proposition holds true--tax-rate cuts are self-financing--if, defining α to be the elasticity of production with respect to the net-of-tax rate:
τ > 1/(1+α)
τ = 1/(1+α)
then tax revenue is at its maximum. If:
τ < 1/(1+α)
then the Laffer Curve proposition fails, and tax-rate cuts are not self-financing.
Arguments that the Laffer Curve proposition fails--that tax-rate cuts reduce revenue--are invariably arguments, with various bells and whistles added on, that the economy's parameter α is in the range from 0.25 to 1, depending, and thus that the critical tax rate τ at which the Laffer Curve proposition becomes true is between 50% and 80%, and thus above the current tax rate t.
Arguments that infrastructure investment is not self-financing should, similarly, invariably be arguments, with bells and whistles, that the net revenue raised ρt--the product of ρ, the comprehensive net rate of return on and thus the income produced by a dollar of infrastructure investment, multiplied by the current tax rate t--is less than the real rate of interest r at which the government must borrow to finance its infrastructure investment:
ρt < r
In a world where the real rate at which the U.S. Treasury can borrow for ten years is 0.3%/year and in which the tax rate t is about 30%, infrastructure investment fails to be self-financing only when the comprehensive rate of return is less than 1%/year.
Now you can make that argument that properly-understood the comprehensive rate of return is less than 1%/year. Indeed, Ludger Schuknecht made such arguments last Saturday. He did so eloquently and thoughtfully in the deep windowless basements of the Marriott Marquis Hotel in Washington DC at a panel I was on.
But Mankiw doesn't make that argument.
And because he doesn't, he doesn't let his readers see that there is a huge and asymmetric difference between:
my argument that tax-rate cuts are not (usually) self financing, which at a tax rate t=30% requires only that α < 2.33; and:
his argument that infrastructure investment is not self-financing, which at a tax rate t=30% requires that ρ < 1%/year.
To argue that α < 2.33 is very easy. To argue that ρ < 1%/year is very hard. So how does Mankiw pretend to his readers that the two arguments are equivalent? By offering his readers no numbers at all.
The data of economics comes in quantities. We can count things. We should count things. Please step up the level at which you play this game, guys...