Here's what Government needs to think about if it's borrowing to invest

Professor Norman Gemmell explores if it would it be sensible for the current government to significantly expand public expenditure even if that meant loosening current borrowing limits.

"[UK Finance Minister] Sajid Javid unveiled a £300 billion (NZ$604b) investment spree as he tore up borrowing rules and reversed decades of Conservative policy with a pledge to revamp Britain's roads, railways, schools and hospitals."

So wrote the UK Daily Telegraph's economics editor as the media there tries to rationalise why a right-of-centre Conservative Party is proposing the sort of public spending spree normally associated with the Labour Party. Is this just another unsustainable pre-election give-away? Have the Conservatives gone "soft" and ditched fiscal prudence? Or is this a sensible policy whatever its proponent's political colour?

These questions are being raised more widely by, among others, respected economists at the International Monetary Fund.

And here in New Zealand Finance Minister Grant Robertson and the Treasury are questioning how much government borrowing is prudent and sustainable. Would it be sensible for the current government to significantly expand public expenditure even if that meant loosening current borrowing limits?

The Economics 101 answer to that question is relatively straightforward. It depends on three conditions being met: 1) the social benefits of extra spending outweigh the cost of borrowing; 2) the economic (and social) impact of that public spending is greater than the equivalent impact if the money were left in private hands; 3) whether the public spending or borrowing "crowds out" private activity – for example, by diverting investment funds to the government does this reduce private investment?

In the current debate, these three conditions haven't changed. Of course, the first condition can easily, but superficially, be met to justify higher spending and borrowing – if sufficient weight is given to the wellbeing of those who will benefit from it. This is why, in political debate, reasonable people can disagree about the merits of higher public borrowing. Those types of cost-benefit calculation are no different now than in the recent past.

Rather, it is the second two conditions that the current debate is challenging.

For the past decade since the global financial crisis, interest rates have been unprecedentedly low, and even negative. Government borrowing has never been so cheap and looks likely to stay low, possibly for decades.

At the same time, central banks across much of the developed world have been throwing liquidity at private banks to try to tempt them into higher lending to encourage investment. But by and large these attempts have failed. Private investors appear to be driven more by the climate of low innovation and productivity growth and political uncertainties (especially in Europe) than by the availability of "cheap money".

If private firms won't do it, why shouldn't the government step up with big infrastructure spending? This should, so the argument goes, raise private sector productivity while helping to eradicate much lamented "infrastructure deficits around roads, schools and hospitals.

Certainly, it can hardly be argued that such spending would crowd out private sector firms' investment – they are self-evidently not doing it, anyway.

All of this points to the government picking up the investment baton that the private sector has, perhaps temporarily, dropped. Just make sure the public investment projects are carefully selected – high benefit-cost ratios – and capable of being reigned back if/when crowding out concerns loom on the horizon.

There can be little doubt this case for more "fiscal stimulus" has become more compelling in a number of countries in recent years as monetary policy has become ineffective through a combination of persistently low and falling interest rates and unresponsive firms.

But a little careful thought suggests that expanding government spending is no panacea. Firstly, choosing the right infrastructure projects with maximum benefit to private industry is no easy task, with limited knowledge about what boosts productivity. And by their nature such investments can take decades to deliver productivity improvements, so will deliver little short-term benefit.

Secondly, and perhaps more importantly, almost all output expansion needs a mixture of new capital and suitable labour. But in New Zealand (as in numerous other countries) labour markets are relatively tight, with employment rates at historical highs, so labour can only be expanded on these projects at the cost of diverting workers from elsewhere. This is the key crowding-out concern in New Zealand: Human capital is the vital constraint, which is not so quickly remedied.

So before New Zealand politicians and their advisers head down the dangerous Muldoonian road of another Think Big public investment spree, they should think carefully about two things:

1. Why is the private sector not investing more despite it never being so cheap to finance it?

2. How can public infrastructure spending best help raise firms' productivity?

Where the prospects of productive public investment look good, at least for the foreseeable future it should cost less for the government to "borrow and invest" than it has in several decades.

Read the original article on Stuff.