by Michael Collins, Investment Commentator at Fidelity
Novmeber 2015
In 1919, a US lieutenant colonel helped lead an 81-strong convoy of vehicles across the US as part of a campaign by the military to highlight the need for better highways across the US. Sixty-two days after leaving Washington D.C., the procession reached San Francisco, having navigated dirt roads, improvised bridges and often no roads whatsoever along the 5,200-kilometre journey.[1]
Thirty-seven years later, this US solider was in a position to fulfil the convoy’s mission. The Federal-Aid Highway Act of 1956 ushered through by President Dwight D. Eisenhower still stands as the world’s biggest infrastructure project. More than US$800 billion (A$1.1 trillion) of today’s dollars was spent in the US to build 75,000 kilometres of highway, 55,500 bridges and nearly 15,000 interchanges. Moreover, the national highway system that bears Eisenhower's name is still prized for its economic, social and even military benefits.[2]
Politicians across the world today often talk about leaving such an infrastructure legacy. For spending on public works is touted as a cure for today’s stagnation, more pointedly as a way to overcome the lack of business investment. Most ruling parties know they need to increase spending to spur growth and many, especially on the right side of politics, reflexively back an infrastructure splash as the best means to do that. The demand for broadband and the need to build or repair bridges, railways, highways, canals and water and sewerage pipes in the world’s biggest cities add further pressure on governments to spend money on public goods.
Infrastructure spending is hyped as an economic cure because its advocates claim that, done well, it boosts productivity, stimulates the economy, aids confidence, increases the quality of life and can help government finances, even if it adds to public debt. Few would argue with these advantages in theory. It’s the “done well” qualification that always proves hard to fulfil. If infrastructure investment does increase, expect lots of dubious, vote-buying and controversial, even corruption-tinged, projects – after all, the corruption watchdog Transparency International rates public-works contracts and construction the world’s most corrupt industry.[3] Expect much bickering about how to pay for the projects and warnings that governments are overloading on debt. These issues will serve to make contentious the economic benefits of infrastructure spending. There is one optimistic thought amid any hullabaloo about white elephants that may ease the public angst if governments do spend big on capital works.
Doing anything grand always generates some opposition, especially when it creates the natural monopolies that are most infrastructure projects. The Democrat-controlled House of Representatives rejected Eisenhower’s highway bill in 1955 because enough lawmakers didn’t want the highways paid for by selling bonds. (A petrol tax was the compromise.) Policymakers these days could surely embark on enough worthwhile public projects to make up for any duds. Not all countries, especially those in the emerging world, have lacked business investment in recent years, the main economic argument for the government to step in and spend on public works. Even if governments in the developed world stay idle on infrastructure, pent-up demand would probably see business investment recover soon enough for that’s how the business cycle works. That’s not the plan. The push is on across the world for governments to invest in infrastructure. It will be part of a strategy to boost productivity while restoring medium- to long-term government finances and taking pressure of monetary policy. Record low interest rates add to the case for public spending but don’t necessarily make it watertight.
Hesitant business
To make a rationale for abnormal levels of public investment – for governments need to do a routine amount under any economic conditions so their economies can function – the lack of private investment needs to be explained. Business investment in advanced economies has only averaged 20.7% of GDP since 2010 (having sunk to 19.5% in 2009) compared with 23.6% of output during the 1990s. An even more stark analysis is that the IMF estimates that private investment in the advanced world has declined by about 20% since the crisis began in 2007 compared with pre-crisis forecasts, a result that compares unfavourably with an average decline of only 10% after previous recessions.[4]
The overarching reason for sluggish business investment is weak economic activity. The US’ so-called Great Recession, Japan’s torpor and the depression in the eurozone have, in effect, created a downward spiral because businesses sensed a lack of demand for their goods and services and have refrained from expanding production. Uncertainty has played a role, too, especially in the eurozone where a sovereign-debt crisis has deterred business from chancing big projects. Other causes are tighter access to credit in countries where banking systems wobbled and higher interest rates in recent years for companies in bailed-out eurozone countries. The Reserve Bank of Australia in June offered the interesting notion that entrenched “hurdle rates” and quick returns are to blame; that businesses look for an expected capital return that, while well above the cost of capital, ignores the cost of capital and that they look for outlays to be recouped within a couple of years, which boosts implied rates of return. “As a consequence, the capital expenditure decisions of many Australian firms are not directly sensitive to interest rates,” the RBA said.[5] Whatever the cause, the decline in business investment is costly for it robs a society of its best chance to boost productivity and, consequently, lift long-term living standards.
If one accepts that weak economic activity is behind the lack of business investment then the economic case is strong for government stimulus. The question thus narrows as to whether investment infrastructure is a worthwhile form of fiscal prodding. The query can become ideological because it can be turned into an argument about the role, size and competence of government in a capitalist system.
Stagnation buster
Better infrastructure is a pressing need in much of the developed world for much of what exists is in need of repair. Yet government spending on public works has stagnated or even fallen in many countries in recent years because lawmakers have prioritised more politically sensitive spending on education, health and welfare over public works when formulating budgets. Investment in budget-surplus Germany, for instance, has averaged just 19.4% of GDP in the past five years compared with 23.8% of output during the 1990s. Infrastructure, like military spending and foreign aid, are easy budget items to trim in prudent times.
Many analysts contend that governments are acting contrary to everyone’s self interest when they prune allocations to public works. Lawrence Summers, the former US Treasury secretary, sees that infrastructure projects are the best antidote to the so-called secular stagnation that has gripped developed economies. He and others argue that when joblessness is high, public works financed by borrowing can stimulate the economy without adding to government debt, whereas – and this is the key to his argument – such projects wouldn’t be stimulatory if they were to be paid for by higher taxes or cutbacks in other areas.
At the same time, the extra boost to the economy from a megaproject can help reduce government debt ratios when real interest rates are low. (A project with a conservative 6% return would boost government revenue by 1.5% of the amount invested, assuming extra income is taxed at 25%, which more than covers the real cost of borrowing at, say, 1%, he figures.) On top of that, government debt ratios would benefit from the extra tax from those employed on the venture and narrow even more if government were to encourage private investment or to use equity financing, tax subsidies or loan guarantees to catalyse a dollar of infrastructure investment at less than the cost of a dollar. “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,” Summers says.[6]
A history of flops
If now’s the time to build the next Snowy Mountains Scheme or even another Sydney Opera House luxury-style project, what should people make of the useless infrastructure governments have built or the money lost on projects that never even get started? The Ord River Irrigation Scheme at the top of Western Australian that was finished in 1971 perhaps best symbolises Australia’s hopeless public-works project, and it’s one that came with environmental damage. It was commenced without proper assessment, funded for political reasons and has never become the food bowl its proponents envisaged. The more-recent National Broadband Network famously never had a cost-benefit analysis before being proposed by the ALP during the 2007 election campaign. Even a less-flashy version being completed by the coalition government looks like costing about 15 times the initial forecast price tag of $4 billion.[7] An estimated $1 billion has been squandered on Melbourne’s East West Link 18-kilometre freeway project without a scratch being made in the ground.
Such failed or controversial publically funded projects are found all over the world, best encapsulated by the putdown, “a bridge to nowhere”. Costs, risks and damaging side effects are usually underestimated in rigged feasibility studies, while revenue forecasts and any benefits are generally exaggerated. Amid all this dubious economics, any environmental harm is minimised. Yet the public interest is often overridden by vested interests. (At least the liberal democratic capital system, by limiting the reach of government, rules out disasters such as China’s Great Leap Forward of 1955-1961, an infrastructure drive of sorts that led to an estimated 40 million deaths.[8])
Even if a project is considered worthwhile, a political fight usually brews over how to pay for it. Higher taxes, more government borrowing, the sale of state assets or public-private alliances are the usual options. In practice (but not in theory where perfect efficiency is assumed), governments can make money out of partnerships. Government can always build something cheaper than the private sector because their borrowing costs are lower and they can fetch a good price if the project is operating successfully. Alas, private-public projects are unpopular because the public has been dudded by so many.
Depressingly for the pro-infrastructure crowd, the economic benefits of public projects are clouded. An IMF study looked at 24 infrastructure blasts since 1969 in 21 emerging countries and found that, rather than inspire a speedier economic growth, such splurges mostly lead to slumps. Either over-extended governments needed to cut back on spending to fix their finances or public spending suppressed private investment. “There is no robust evidence that the investment booms exerted a long-term positive impact on the level of GDP,” the paper found. It concluded by saying that any public-sector boom in coming years will only be beneficial “if governments do not behave as in the past and instead take analytical issues seriously and safeguard their decision process against interests that distort spending decisions”.[9]
If you think developed countries would do better, remember that investment in infrastructure has never revived Japan’s economy for long. But taxpayers can take one solace if they think billions will be wasted on public works. Even projects that cost money in an accounting sense generally have vastly understated immediate economic Keynesian benefits. Useless public investment still stimulates an economy. It’s better than no spending. But perhaps against all expectations, today’s politicians will prove to have the Eisenhower touch.
Financial information comes from Bloomberg unless stated otherwise.