Infrastructure stimulus will be counterproductive

February 23, 2013

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.

19 December 2012, PPPJ

Filed under transport Tagged with , , ,

Pride before a fall: Osborne looked to special interests, not the UK’s perilous state

February 23, 2013

The Autumn Statement showed that George Osborne has failed to grasp the gravity of the economic crisis facing the UK. Urgent action was needed to brace the economy for double-dip recession and the fallout from the euro crisis. Instead, the chancellor announced a big increase in government borrowing, together with a series of measures that, while attractive to key groups of target voters, will do little to encourage growth.

Worse still, collapsing growth means the government’s deficit reduction plan is now in tatters. Government borrowing has been increased by £110bn over the next four years, meaning a staggering £350bn added to the national debt.
This may in fact be a best-case scenario. The Office for Budget Responsibility predicts slow growth of 0.7 per cent in 2012 but then assumes a healthy recovery, with growth rising to 2.1 per cent in 2013, 2.7 per cent in 2014 and a robust 3.0 per cent in 2015. But given the severity of the euro crisis, high levels of public and private debt, and the possibility of a downturn in overheated emerging markets, it is equally plausible that Britain will go into recession next year, followed by several years of stagnation.

A wise chancellor would be preparing for such a scenario. Vague talk of contingency plans does not pass muster.
A double-dip recession would decimate tax revenues while adding to welfare spending through higher unemployment. If UK GDP were just five per cent lower than predicted in 2015, for example, this would reduce the annual tax take by around £35bn.

Under such circumstances, with the budget deficit remaining unsustainably high, the chancellor cannot assume that the UK will retain investor confidence and continue to pay very low interest rates on its debt. With high debt and low growth there may be little to separate Britain from the struggling economies in the rest of Europe, such as Spain and Italy.
Given the severity of the potential risks, Osborne should have had the courage to announce further cuts – at least enough to return the deficit reduction plan to its original trajectory. He should also have taken far bolder steps to encourage growth, through radical deregulation and by rationalising the tax system.

He could, for example, have cut spending by uprating benefits rates in line with average earnings rather than inflation. Planned increases in foreign aid – deeply unpopular with a sceptical public – could have been abandoned at negligible political cost.

Instead, several new spending announcements were made, using money that could have been used to reduce government borrowing. Ill-conceived “credit easing” policies will mean taxpayers will guarantee risky loans to businesses and first-time buyers. Additional enterprise zones were announced, even though these subsidise firms to relocate to sub-optimal locations. An extra £1bn was found for the Regional Growth Fund for England, despite five decades of failure in regional policy and governments’ lamentable record at picking winners.

Much was also made of extra infrastructure spending: £5bn extra over the next three years plus significant additional investment from the private sector. Unfortunately, a high proportion of this expenditure is politically motivated and the economic returns will be negative. Loss-making public transport schemes will require ongoing operating subsidies, creating significant future liabilities for short-term political gain.

The counterproductive gimmicks were combined with almost a complete absence of policies to reduce burdens on businesses and thereby encourage growth. Osborne made some welcome statements on the need to liberalise planning controls, reduce the cost of employment law and simplify business taxes – but few concrete measures were announced.

In fact, current government policies are likely to work in direct opposition to many of the chancellor’s announcements. For example, new regulations forcing builders to produce expensive “zero-carbon” homes will dwarf the impact of special help for 100,000 first-time buyers. Indeed, Osborne recognised the calamitous impact of the government’s green policies when he announced subsidies for energy-intensive industries struggling to cope with spiralling costs.

The lack of action on deregulation is mirrored in tax policy. Several tax rates are now so high that they actually lower revenues by destroying incentives to work and invest. The Autumn Statement was a golden opportunity for Osborne to signal his intention to rationalise the tax system. In particular, a cut in the 50p rate of income tax would have increased tax revenues and sent a strong message to international investors that the UK offers a pro-business climate.

On this and other issues the chancellor proved too timid to step up to the challenge. He missed his chance to prepare the country for economic turmoil by cutting spending and removing key impediments to growth. It now seems likely his hand will be forced by events.

30 November 2011, City AM

Filed under regulation, tax Tagged with ,

Set the economy free to meet tough challenges ahead

February 23, 2013

Despite the cuts, the coalition government will raise the national debt by almost £500bn over this Parliament. This is just the official debt. When other liabilities such as pensions are included, the total debt is already £5 trillion and heading higher. This amounts to a staggering £80,000 per person in the UK.

If the government thinks the cuts will solve the problem, it is deluding itself. In real terms, public expenditure will fall by just three per cent by 2015. Spending on politically sensitive areas such as health and welfare will be maintained, while the foreign aid budget will actually be increased. More money will also have be spent on interest payments as the debt continues to rise.

Recent tax rises won’t solve the debt problem either. Indeed they may even make it worse. When tax rates are already high, increasing them further tends to reduce the amount raised.

Take the 50p rate of income tax. This will deter hard work and encourage tax avoidance strategies. It will also make it harder for UK-based firms to attract top international talent. Some companies may even decide to move elsewhere.

Higher taxes destroy wealth and make both individuals and the government worse off. With little room for manoeuvre on tax rates and cuts, the Chancellor hopes that economic growth will deliver the extra revenues needed to balance the books. But if the recovery falters, the public finances could be in deep trouble again.

Worryingly, there are several reasons to be pessimistic on the economy. The massive surge in government spending under New Labour is thought to have knocked at least one per cent a year off Britain’s trend growth rate. An increasing share of resources has been devoted to inefficient public-sector projects rather than the private-sector investment.

The situation is worsened by a rapidly ageing population. The importance of the “grey vote” makes it far more difficult to reduce public spending on the elderly, and they have largely been shielded from the cuts so far.

Yet without a more radical approach to issues such as public sector pensions and healthcare, government debt levels are likely to carry on growing and there will be upward pressure on taxes.

On top of serious demographic challenges, there are several less predictable factors that could drag down growth. These include the euro crisis and rising oil prices. After unsustainable booms, large parts of Europe now face a prolonged slump. Britain will inevitably be affected by these problems, particularly if taxpayers end up funding bailouts of major countries such as Spain and Italy.

A 1970s-style oil crisis could be even more serious than continued turmoil in the eurozone. Political upheaval in North Africa and the Middle East has already helped send prices to record highs, raising costs for businesses. Britain’s North Sea Oil reserves previously offered some protection from this kind of shock. But they are dwindling rapidly – a trend likely to be speeded up by George Osborne’s short-sighted windfall tax on oil and gas production.

Higher energy costs will also result from the government’s environmental policies. Around £200bn will be diverted into power projects such as offshore wind farms over the next decade, largely to meet ambitious climate change targets. As a result, businesses outside the energy sector will be starved of investment capital. Their growth will be further hampered by higher fuel bills and it may also be necessary to raise taxes to address rising fuel poverty.

These extra costs will pile on the misery for struggling small enterprises already suffocated by red tape. But rather than deregulating, the coalition has added yet more burdens. Examples include the Equality Act, the extension of paternity leave, new controls on migrant workers and increases to and extensions of the minimum wage.

With so many reasons to be negative about the UK’s growth prospects, it would hardly be surprising if government forecasts prove too optimistic. The consequences could be dire. A slower than expected recovery would mean the deficit remained at unsustainable levels. This could undermine the government’s credibility on the financial markets, pushing interest rates higher. In the worst-case scenario, Britain could be caught in a Greek-style debt spiral, having to borrow more and more money just to afford interest payments.

Radical action is therefore needed to lower government debt, particularly given the risk of a serious external shock within the next few years. The cuts need to be deeper and should be combined with a systematic programme of deregulation. Rather than paying lip service to the growth agenda, the coalition needs to reject decisively the wealth-destroying policies that hamper businesses.

13 April 2011, Yorkshire Post

Filed under regulation, tax Tagged with , ,