Investment in infrastructures: an appetising proposition but often with unexpected consequences
After a long time wandering the desert, a large number of advanced countries are now thirsty for growth, especially the main countries of the euro area. Given this situation, the benefits which, according to the IMF, could be enjoyed through large-scale investment in infrastructures have been welcomed by many countries like rain after a drought. Several also see this as a chance to renew infrastructures that have deteriorated after years of continuous public spending cuts. Nevertheless the success of such a programme is not guaranteed. It is obviously crucial to choose the right project to finance but how such projects are financed, the macroeconomic context and level of debt are equally or even more important. Some of these factors are now advantageous but there are others that could represent a threat.
The figures provided by the IMF are truly appetising: an unanticipated increase in public spending of 1 pp of GDP increases the level of output by 0.4% the same year and by 1.5% after four years.1 In the short term, this effect on economic activity occurs through greater demand and the possible knock-on effect of private investment while the long-term economic impact results from supply, increasing the output of the country's economy.
The IMF has also noted that the impact on demand is even greater during a weak economic context where there is surplus productive capacity. The macroeconomic impact can also be greater if public investment is debt-financed as this helps to adjust the cost of financing the programme more closely to the timescale for any returns on this investment. In other words, it avoids having to raise taxes or cut public spending in the short term, while the investment has yet to produce any return. Debt-financed investment is particularly attractive in the current monetary environment with rock-bottom real interest rates. This is therefore an appetising proposition for those economies that have yet to define a roadmap to ensure more vigorous and sustainable rates of growth in the long term.
However, the IMF's report contains one important proviso. Countries with debt that is already high must remember that, in the short term, a programme of such characteristics could entail undesirable effects. Given that such investment projects are normally long-term, if the potential productivity is not sufficiently credible, doubts may emerge regarding the sustainability of public finances. There are several economies in the euro area that must take this risk very much into account but others, such as Germany, have greater margin and could seriously consider the IMF's proposal.
1. See Chapter 3 of the IMF World Economic Outlook for October 2014. The IMF assumes that the investment's impact on infrastructures is very similar.
