Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday 5 November 2016

Public investment and fiscal rules

When I started writing this paper with Jonathan Portes, I was genuinely unclear about whether fiscal targets should be for the total deficit (which includes public investment) or for the current balance (which excludes it). This was partly because some of the conventional reasons for excluding investment seemed poor. For example, to assume all investment paid for itself in the form of higher activity and therefore higher taxes is obviously wrong. To avoid this by having each project treated on its own merits (it would happen if it generated a social return greater than some cut-off or interest rate) is better but ignores the uncertainties that any such calculation inevitably involves.

By the time the paper was finalised, and later when it came to proposing a rule that the Labour party could adopt, it was clear to me that any target should be for the current balance, with a separate target for the public investment to GDP ratio. We can see a very strong argument for doing that right now. Jean Pisani-Ferry is one of a steady stream of economists saying that it really is time to increase public investment, and they are backed up by international organisations. But despite all this being true for some time, there is very little sign of governments taking much notice. As Pisani-Ferry notes: “On average, governments are using the gains implied by lower interest rates to spend a bit more or to reduce taxes, rather than to launch comprehensive investment programs.”

The political economy reason why this is happening is straightforward enough. When both current and capital spending have been squeezed for some time, if this constraint is partially relaxed governments have a choice. Public investment generally benefits future generations as well as voters today, while current spending all goes to the current generation. Governments who aim to maximise votes for themselves will therefore tend to ignore investment spending.

Exactly the same process happens in a recession. It is generally easier and less painful to cut an investment project than fire some nurses or teachers. The danger with deficit targets is therefore than whenever these targets bite, public investment is the first to suffer. This is exactly what happened in the UK in 2010 and 2011, which accounted for a great deal of the deflationary impact of the Coalition government’s fiscal consolidation.

Those in the know will point out that the Coalition’s main fiscal target was for the current balance. That is why it is vital to also have a separate target for the public investment to GDP ratio. That would ensure that over the next few years governments do not just pretend to do something about infrastructure and other public investments by funding one or two high profile projects, while continuing to keep overall public investment low. That is what George Osborne did, with planned investment over the next five years between 1.5% and 1.9% of GDP. If Philip Hammond does not change these plans to something more like 3%, we will have another Chancellor who talked the talk on investment but is not prepared to put money where his mouth is.


  1. What do you think about the risk that such accounting rules unreasonably bias spending towards physical infrastructure rather than education and other social investment? It seems quite possible that extra education spending might often be the better investment.

    1. I think the definition of investment used should follow the economic logic and not statistical convention.

  2. I think you came to the right decision.

    For public investments that create a pecuniary return, the standard tax-smoothing argument says they should be deficit-financed.

    For public investments that create a non-pecuniary (psychic) return, intergenerational equity (those who benefit should pay) says the same thing. Only the annual depreciation and interest charges should be paid currently.

  3. How about nit targeting the deficit at all, and instead targeting things that actually matter, such as unemployment. Inflation and growth? As Keynes said 'look after unemployment and the budget will look after itself. Problem with targeting the deficit is that it just encourages procyclical spending, which is the exact opposite of what governments should do.The public is never going to understand why it is often better for government to spend more when the economy is weak and less when it's strong, which is why they fall for the austerity story. Deficit targets just encourage that mindset, and are unnecessary and usually self-defeating.

    1. Your argument is really that interest rates, outwith the ZLB, cannot effectively control demand.

    2. Prof Wren-Lewis, I don't think Anon or anyone else suggests that interest rate adjustments "outwith the ZLB" don't work. The question is whether they are the best way of doing the job. Strikes me there are two fundamental problems with interest rate adjustments. First, to cut rates in a recession assumes the recession was caused by inadequate lending, borrowing and investment spending, when in fact it may easily have been caused by lack of some other type of spending.

      Second, to artificially adjust interest rates means rates at something other than the free market rate, which on the face of it mis-allocates resources. The free market rate obtains where the state borrows nothing to fund current spending: borrowing to fund current spending is generally frowned on quite right. As to borrowing to fund capital spending, the arguments there are much weaker than is generally accepted (Milton Friedman opposed all forms of government borrowing). But if government DOES BORROW to fund capital spending, it cannot then logically print money and buy back government bonds with a view to cutting interest rates because that amounts to funding capital spending via printed money, which contradicts the idea that capital spending should be funded via borrowing. Sort of check mate that, isn't it?

  4. Another way to say this is: The near zero percent environment what actually initiated was: 1) Banks putting their money in Dow Jones and Nasdaq rather than lending, while 2) private investments where put in creating new glass building around London whose value increased while demand for those same construction was never there or decreased. The government role comes here and as a result of this is what is explained above. There are many ways to explain this but in reality everything comes down to one thing. They are not interested in increasing public investment. Perhaps just some overvalued construction in central London assigned to a private company.

  5. SW-L, First, where’s the logic in a “fiscal target”? If by that you mean the deficit, the deficit (as Keynes pointed out) needs to be whatever deals with unemployment. Thus to have a “target” for this time next year or two or three years down the line is nonsense because no one knows what the economy will be doing then.

    Second, since expenditure on public investment inevitably influences stimulus, it’s impossible to totally disentangle a deficit specifically designed to bring stimulus, and deficit the main aim of which is to fund public investment, but which inadvertently brings stimulus.

  6. I don't know how you do it in the UK, but it is unbelievable that the US federal government does not have a separate capital budget from the annual operations budget. This creates many problems including how to rate projects for whether or not they should go forward.

    It's also a problem because in Congress we have so many anti=government people that they don't want to support long term investment in federal government facilities or in buildings for regulatory authorities (like the Consumer Financial Board).

    In DC too, we have this problem. Most local governments maintain separate processes for funding capital projects from annual operations. Our city does not.

    I have written about this a lot, but not from your perspective because that's not my background.

    My general point is we need to look at such projects in terms of their contribution either positive to economic and government activity, neutral, or negative. And focus on ensuring the all projects have marginally positive gains.

    I have not yet had the privilege of visiting the UK, but I read a bunch of the planning documents from local governments, and it seems as if your system is much more focused on asset and risk management than is the case in many jurisdictions in the US. (Irrespective of the other problems forced by the centralization of government in the UK and how the local governments are at the mercy of distant decision making completely disconnected from the reality of municipal finance, e.g., Liverpool).

    I wrote a piece last year about how elected officials should think of themselves in part, as asset managers:

  7. It seems to me highly probable that the conservatives will remain in power the next general election, regardless if it's called early or not, I'm sure May is of the same thought.
    Therefore, I think that the current reason for ignoring investment spending has more to it than just to get more votes. I may be wrong and I lack the foresight to add weight to this thought.

  8. Unfortunately I have not been able to access yet Simon's original article (which no doubt provides the methodological/theoretical underpinning for the public investment/GDP ratio), but would like to venture some comments of the (hopefully intelligent informed layperson variety) and leave aside any direct observations on its relationship to the New Keynesian framework that Simon I think subscribes to:role of monetary policy, in effect, is to control (as far as it can) demand and the real economy, while role of fiscal policy is confined to control of the deficit and public debt.

    1 If government were prepared to accept such a ratio and the rationale for it, they would be prepared in any case to increase investment, and vice versa; it really is a political economy/choice issue at that level. Having a third fiscal rule that, in effect, forbade governments in power to reduce public investment during recessions and their aftermath as that is pro-
    cyclical seems sensible: but Simon, himself, in his succinct style spells out why they would be reluctant to accept such a rule. Something for the Opposition then?

    2 Clearly public investment needs to be efficient as well sufficient. Projects needs to be accessed and ranked according to their economic and social return relative to their costs, discounted over their life. Tall Order! Who is going to that in a non-political way? A subsidiary rule to the proposed rule could be that an independent body,such as a National Infrastructure Commission,takes on that as a statutory remit; but that would require another delegation of political authority.

    4 Definition of public investment would indeed be tricky in terms of excluding or including spending on human capital, schools and other non-direct return investment. Why not include
    spending on youth clubs or crime reduction. Where should the line be drawn?

    3 A key argument against using public investment to kick start a sustainable recovery is that the positive impacts tend to be short-lived as their effects are discounted by economic actors,and the overall determinants of the recession in the first place,re-exert themselves. I would counter that by the argument that given modern economic conditions in the industrialised countries, full employment requires higher levels of public investment as a first order principle in order to replace debt-financed consumer expenditure,which inevitably leads to boom-bust. That principle needs to drive and underpin any new fiscal rule focused on safeguarding public investment.


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