It could be argued that while the G20 has, by and large, avoided several of the policy mistakes of the Great Depression, it has perhaps overlooked the role that public investment, particularly in infrastructure, and including public works on a large scale (which were undertaken during the Great Depression), can play in the global recovery.

The latter can substitute for the lack of private investment. When consumers, investors and export markets are in retreat, arguably the only way to sustain growth is through an expansion in government demand.

Governments can stimulate the economy either through tax cuts, or by directly increasing their own expenditure. Tax cuts have the advantage of being easier to roll back, unlike public expenditure which tends to be sticky. By reducing taxes, government leaves additional funds in private hands for consumption and expenditure.

However, where private balance sheets are impaired, these additional funds might be used to draw down debt rather than in higher consumption or investment. Even in the absence of deleveraging, if tax cuts are perceived to be temporary, rational expectations may come in the way of translating these into spending.

In a recession induced by a financial crisis, therefore, tax cuts may be less effective than an increase in direct government expenditure as a tool for stimulating the economy. Likewise, by relying on direct public spending to stimulate the economy, the role of macroeconomic policy transmission channels becomes of secondary importance.

PUBLIC SPENDING EFFECTS

Public investment also has the potential to lay the foundations of medium-term growth if the investment is in infrastructure, since this has the effect of raising the growth potential and also crowds in private investment, unlike other kinds of government expenditure which may actually crowd out private investment.

Infrastructure investment, therefore, has both supply side and demand side features. Capital expenditure also typically has higher fiscal multipliers. A recent study by UNCTAD has also found a strong correlation between investment in fixed capital and job creation in developed countries.

It could be argued that running high fiscal deficits at a time when public debt levels are already high would be counterproductive as it would further undermine market confidence and growth.

As we have seen, however, austerity in the absence of growth is perhaps even more counterproductive, as it may neither put the economy back on the growth trajectory nor control rising deficits and debt.

We have also seen that sovereign borrowing costs have actually been driven down despite mounting deficits and debt, except in the case of peripheral Euro Zone countries, which is a peculiar phenomenon induced by monetary union.

It may be recalled that the underlying instability in the global economy prior to the recent crisis was caused by a glut of savings relative to investment that drove down interest rates, encouraged risk-taking and led to an artificial leveraged consumer boom in developed countries.

The investment and infrastructure requirements in developed countries are likely to be quite different from that in developing countries as the “traditional infrastructure” is already largely in place.

The investment is likely to be in rebuilding and upgrading existing infrastructure, much of which was put in place long before the more modern infrastructure in emerging market economies (EMEs), who have, in a sense, reaped the advantage of late development. There is also a latent demand for smart grids and green infrastructure in advanced countries.

RESKILLING REQUIREMENT

Infrastructure centred on natural gas, particularly shale, also presents a huge public investment opportunity. There is also need for putting in place a new infrastructure that creates high-end skills, as it is likely that future job creation in advanced countries would be in high-end manufacturing and services, rather than in labour-intensive or medium skill areas in which emerging markets are more competitive.

While such public investment would stimulate growth and job creation directly, it would also crowd in private investment and job creation indirectly by generating a large demand for capital goods and appropriately re-skilling the labour force.

It is sometimes argued that there may not be “shovel ready” infrastructure projects on the scale required to drive the global recovery in advanced economies, as these have a relatively long preparation period. The large gaps in the provision of traditional infrastructure, especially in developing countries, are well known.

Indeed, it is these countries that have shovel-ready infrastructure projects. If this huge investment demand can also be leveraged through globally coordinated initiatives to boost funding for infrastructure, the demand created for capital goods would also spill over to advanced economies.

This would be a win-win situation, as it would also accelerate the demand rebalancing required for the global economy to get back to a sustainable higher growth trajectory.

It needs to be recognised that in cases where there is little room to alter agreed fiscal adjustment paths, greater attention would need to be given to restructuring existing stimulus programmes than to expanding their size.

It also needs to be recognised that greater funding and investment in infrastructure may not be an optimal solution in all countries that may need to focus more on rebalancing demand towards domestic consumption. It also goes without saying that the focus on investment should not detract from the imperative for structural reforms necessary to encourage private sector job creation. The dangers of creating “white elephants” and “pork barrel politics” would also need to be mitigated.

FINANCIAL EXCESSES

Regardless of these caveats, taking emerging market and developing economies (EMDEs) as a whole (and perhaps some advanced economies as well), there is an argument that long-term funding and investment in infrastructure may assist the objectives of furthering development, rebalancing, reviving growth and creating jobs.

A major thrust in public investment in infrastructure is likely to push up growth rates even over the short term, create jobs and increase growth potential. But will it be self-sustaining? Japan is a cautionary tale in this regard. It has been trying to stimulate its economy back to growth over the last two decades through public investment, but private growth and investment are still to materialise, while its public debt has ballooned.

Another big dose of public investment in the post-Tsunami period has again boosted its growth, but nobody expects this to be permanent. For the growth to be self-sustaining, there would also need to be a back-loaded demand rebalancing from public to private. While this could partly be done through transfer of public works to private hands, where appropriate, this would ultimately come with the revival of household demand.

It may be recalled that the high growth rates during the Great Moderation were facilitated by excesses of the financial system that enabled consumers in advanced countries, particularly in the US, to go on a consumption spree far in excess of their income generating ability. Return to these former levels of consumption is both unsustainable and unlikely without new growth drivers.

Infrastructure investment can be one such growth lever. Increase in final consumer demand in surplus countries can be another. For deficit countries to exploit these opportunities, they need to become more competitive by implementing ambitious product and labour market reforms.

(The authors are Chairman and Secretary, respectively, PMEAC.)

Excerpts from "Growth or Austerity: The Policy Dilemma", ICRA Bulletin, Feb 2013

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