The International Monetary Fund’s annual report on the UK economy calls for the Chancellor to boost economic growth through investing in infrastructure.
While the IMF is right to make this point, we must ensure we do not once again become bogged down in the simplified debate around “austerity vs stimulus” that has dominated policy discussion in recent years. Economic growth will only return through what is known as “investment spending” on planes, trains and other projects with a strong “multiplier” effect.
Spending, multiplied
Here’s how the argument works. If the government decides to build a new rail link, or a new runway at an airport, then construction workers are employed, and their suppliers increase production to provide the goods needed during the building. There is a boost to employment in both construction and manufacturing. These workers then go out and spend their earnings, further boosting income and employment.
This ripple effect through the economy continues, boosting output and jobs still further. Economists call this positive spill over effect the “multiplier”. For every pound of spending, you get back several times more, since the extra income and employment generates higher tax revenues. And this reduces the government’s deficit.
Construction projects in infrastructure have particularly high multipliers as, in the longer term, they also help the economy work better. Better transport links, for instance, reduce costs to businesses and commuting times for individuals.
The boost to manufacturing is also important. Despite the growth of the service sector over the past few decades, manufacturing is still the “engine of growth”. So boosting manufacturing is important in securing long-term growth.
This tells us that government spending on “investment” can reduce the deficit and have positive short- and long-run effects on employment and income.
Examples of investment spending might include the proposed Heathrow expansion, investment in high-speed rail (HS2), the expansion of urban light rail (tramway) systems, and the construction of road schemes that cut congestion and link major cities together effectively.
Stop the consumption, start the investment
But before we get carried away, not all government spending has the same beneficial effects. Government spending that is “consumption” rather than “investment” has a much smaller multiplier effect. So increasing transfer payments, such as welfare benefits, would not have anything like the positive economic effect generated by investment projects.
Spending on local construction projects, such as cosmetic regeneration schemes in run-down areas and traffic calming measures, would also not be capable of generating large multiplier effects, since these don’t have the longer term benefits of large investment projects.
Government spending that “distorts” the economy can also have negative effects. Current energy policy that offers subsidies to renewable energy providers and artificially increases costs to individuals and businesses (for example through carbon price floors) fall in to this category. These “green” policies are arguably holding back economic growth.
Tough choices
The take away message is this: cutting the public deficit and boosting growth is not as simple as it is made out to be. Neither cutting public spending, as advocated by many on the right, nor increasing public spending, as advocated by many on the left, provides us with a complete solution.
It is about spending more on projects which have a strong investment component. Projects which boost construction and manufacturing to begin with but also yield a longer term benefit to the infrastructure of the economy, giving it the room to grow in future.
Heathrow expansion and HS2 are good examples of projects that would deliver exactly these investment benefits - strong multiplier effects, a boost to UK manufacturing, and long term infrastructure improvements to build future capacity for growth.
A focus on infrastructure spending means making tough decisions on welfare spending. And it means reversing current thinking on energy policy. None of this is easy or uncontroversial, but government “investment” really is the key to growth.
The IMF appear to have realised this. Now it is the Chancellor’s turn.