I read an interesting report this morning, which resonated with some other work I had…
It is hard to imagine that so little progress has been made in dismantling the mainstream macroeconomics paradigm over the last decade within the institutions of government. We have had the GFC, and now, the pandemic to disclose what does and does not happen when governments engage in relatively large fiscal shifts, yet the fictional world that is taught in mainstream university programs and echoed in policy making circles keeps being rehearsed. While researching the literature on rates of return on public infrastructure spending for a project (book chapter) I am working on at present, I came across the starkness of the mainstream deception. They are still claiming that public spending damages private spending.
On June 16, 2016, the US Congressional Budget Office released a report – The Macroeconomic and Budgetary Effects of Federal Investment – which purported to show that “Federal investment in physical capital, education, and research and development boosts private-sector productivity gradually” but reduces funds available for private investment.
It also claimed that “federal investment ultimately yields a return that is one-half as large as the return on the average private-sector investment.”
I searched the document for references that were cited to give authority to this assertion.
The earlier literature that I am familiar with found almost exactly the opposite outcomes and one of the recent papers cited by the CBO, came up with results that seem contrary to CBO’s interpretation.
Further, there was no evidence to support the principle finding that:
Increased federal borrowing reduces the amount of money available for private investment … CBO’s central estimate is that for each dollar that the federal deficit increases, domestic private investment falls by 33 cents. That reduction in private investment results in a smaller capital stock, eventually shrinking output.
Another assertion based on their internal modelling, which is constructed to deliver that result.
The CBO lives in a parallel universe
The CBO basically lives in a fictional world and it is little wonder that the advice being given to the US government is so defective.
The early work on this subject came from David Aschauer in seminal papers published while he worked at the Federal Reserve Bank in Chicago.
1. Aschauer, D. (1989a) ‘Is Public Expenditure Productive?’, Journal of Monetary Economics, 23 (2), 177-200.
2. Aschauer, D. (1989b) ‘Does public capital crowd out private capital?’, Journal of Monetary Economics, 24 (2), 171-188.
As an aside, David Aschauer drowned while smimming in a triathlon in the US in 2011.
These papers really put the ‘cat among the pigeons’ because they challenged the basic ideas that mainstream macroeconomics is built on – that government spending on infrastructure – roads, bridges, airports – undermines private investment spending (crowding out) and undermines productivity growth.
David Aschauer was motivated by the empirical reality that the strong public infrastructure spending in the 1950s and 1960s was associated with strong growth in overall productivity, and, when public investment started to decline in the 1980s as the neoliberal attacks on fiscal intervention increased and became dominant, productivity growth started to decline as well.
His deep econometric modelling established what he considered to be a causal relationship between increased public spending and enhanced output and productivity growth, and, importantly, he found that public expenditure on infrastructure actually ‘crowded-in’ private investment.
In other words, the two types of investment spending – public and private – were complements rather than competitors.
His results suggested that the rate of return on public infrastructure investment was around three times higher than the return on private capital formation.
A shocking result for the mainstream contention, that organisations like the CBO still like to deny (as above).
There were several supportive research articles published after this seminal work that all supported the result.
1. Munnell, A.H. (1990) ‘Why Has Productivity Growth Declined? Productivity and Public Investment’, New England Economic Review, Federal Reserve Bank of Boston, January/February, 3-22.
2. Lynde, C. and Richmond, J. (1992) ‘The Role of Public Capital in Production’, Review of Economics and Statistics, 74 (1), 37-44.
3. Lynde, C. and Richmond, J. (1993) ‘Public Capital and Total Factor Productivity’, International Economic Review, 34 (2), 401-14.
Of course, the attacks dogs went to work and several papers came out criticising the econometric approach that David Aschauer had used.
I won’t go into the technical details but for those who are interested in these things the criticisms centred on issues of simultaneity (in other words, the relationships found were not real and were driven by a trend in all similar variables) and causality (in other words, what causes what – that output growth drives public expenditure growth rather than the other way round).
A more recent study in 2010 by James Heintz used up-to-date techniques, which resolved any of the econometric issues in the earlier studies and found that David Aschauer’s early work was meritorious.
There was indeed a strong positive impact on private productivity growth arising from increased public infrastructure expenditure, which once again destroys the sort of estimates that organisations such as the CBO pumps out.
Reference: Heintz, J. (2010) ‘The Impact of Public Capital on the U.S. Private Economy: New Evidence and Analysis’, International Review of Applied Economics, 24 (5), 619-32.
Some simple calculations using the estimates provided by the work of Heintz would suggest that the rate of return on public investment in terms of extra GDP is somewhere between 30 and 40 per cent.
Later, a ‘meta study’ from two European-based researchers Pedro Bom and Jenny Ligthart – What Have We Learned from Three Decades of Research on the Productivity of Public Capital – (published in 2014 in the Journal of Economic Surveys, 28 (5), 889-916) – confirmed several important results, that were applicable to all economies.
Effectively, ‘meta analysis’ seeks to resolve the differences across many studies by deploying “statistical methods to summarize, evaluate, andanalyze empirical results across studies; it presents a systematic and objective way to explain and control for the study-to-study variation.”
They investigate 578 instances where researchers have studied the relationship between public infrastructure spending and GDP growth.
Their final estimates are below those derived from David Aschauer’s initial work but still strongly positive.
For example, they find a return on public capital infrastructure (depreciation adjusted) of around 14 per cent, which increases when ‘regional’ capital spending (state/local government) is considered.
The regional estimates are subject to downward bias because of the interregional ‘spillover effects’, where investment in one region/state has productive impacts on neighbouring regions/states (perhaps due to a new bridge, road network etc).
The ‘meta study’ isolated 31 separate US-focused research projects in this field and determined that the average return on public investment was high and much larger than the CBO claimed in the paper cited above.
The CBO estimated that the private rate of return is 10 per cent (“that a $1 increase in private investment, all else being equal, increases output by 10 cents over a year”) and “the average rate of return on federal investment … is about 5 percent.”
The CBO use the Bom/Ligthart paper as an authority although they came up estimates of the relationship between public infrastructure spending and output that was twice as large as the estimate CBO base their own work on, which is how they get the 5 per cent rate of return estimate.
While the CBO claim that their “judgement” is “consistent with the range of estimates found in the research literature”, I would disagree. Their estimates are well below what most researchers in the area would think reasonable.
So my reading of the literature, contrary to the CBO’s conclusion, is that the best research results we have at present indicate that there are strong gains arising from government infrastructure spending.
Why ‘financing’ doesn’t matter
The CBO claim that their estimates are conditional on the ‘financing’ methods for the government spending increase.
They analyse two cases: “reducing other spending and increasing federal borrowing”.
The first option is considered the best return on the infrastructure spending because they assume that cutting other public spending to create the offset has no negative consequences for output growth.
The borrowing option sees the CBO wheel out the fiction plus.
… the increase in federal borrowing would reduce the amount of money available for private investment, damping GDP in later years.
The CBO identify two negative impacts:
1. “the Federal Reserve, in CBO’s view, would respond by raising short-term interest rates to prevent inflation from rising above the central bank’s longer-term goal.”
2. “increased borrowing would reduce the amount of money available for private investment, thereby heightening competition for investors’ money.”
Clearly, this report pre-dated the massive shift in Federal Reserve thinking in August 2020, where they abandoned the NAIRU approach – the forward-looking hike rates to suppress the possibility of inflation – in favour of a backward-looking approach, to wait until inflation was entrenched in their ‘targetting’ range (even though they haven’t an explicit range) before acting on rates.
That shift in Federal Reserve thinking has been significant and explains why interest rates have not been rising quickly in the US, in response to the supply-side induced inflation spike over the last several months.
Mainstream economists teach that when national governments run deficits and issue debt, they crowd out private spending.
The assertion is a central part of the mainstream attack on government fiscal intervention.
At the heart of this conception is the Classical Loanable Funds Theory, which creates a fictional rendition of the way financial markets work.
For our purposes, the crowding out hypothesis is based on the claim that at any point in time, there is a limited supply of private sector saving for which government borrowing and private sector borrowing compete.
If government tries to borrow more, by issuing and selling more bonds, then the competition for finance would push up interest rates as the demand for saving rises relative to a scarce supply.
The upshot is that some private firms would then find that the higher borrowing rates render their investment projects unprofitable and so private investment expenditure falls.
They also claim that private investment spending is always more productive and desirable (because firms have to face the market test to survive) than government spending, which is characterised as being relatively wasteful because there are no shareholders to ‘keep government honest’.
A careful understanding of what drives saving and how banks actually operate shows that the basic crowding out hypothesis is inapplicable in modern monetary systems.
First, government deficits stimulate sales, which leads to higher GDP (income). As a result, the pool of savings expands because saving is a function of GDP (income).
The Italian economist Luigi Pasinetti once noted that “investment brings forth its own saving” – an astute observation that applies to all spending sources.
The other way of understanding this is that government deficits generate non-government surpluses that accumulate to increased wealth holdings in the non-government sector.
Since there are more savings and greater financial wealth, government borrowing does not reduce the pool of funds available to private sector borrowers.
Quite the contrary.
Second, if we examine the way modern banks operate, it further becomes obvious that the crowding out conjecture does not apply to the real world.
Students in mainstream banking courses are told that commercial bank lending is reserve constrained.
That is, banks are considered to solicit deposits from lenders, which then allows them to build up reserves that they can then loan out.
But in the real world, bank loans are not reserve-constrained.
Banks do not just sit around waiting to dollop out their current deposits to lenders in some sort of rationing plan.
Banks solicit credit-worthy borrowers to extend loans to. Importantly this means that loans create deposits, not the other way round.
So, there can never be ‘financial crowding out’ in a modern monetary economy.
Fiscal deficits do not reduce the capacity of private borrowers to access funds in the financial markets.
Organisations such as the CBO continue to run the mainstream line and influence government policy adversely, as a consequence. While the report analysed here was written in 2016, more recent material published by the CBO reveals they are still pushing the line that public spending damages private spending.
It remains a long haul to change this institutional inertia.
Our edX MOOC – Modern Monetary Theory: Economics for the 21st Century continues
We are off and running again for another year with the first day of our MMTed/University of Newcastle MOOC – Modern Monetary Theory: Economics for the 21st Century.
The course is free and will run for 4-weeks with new material each Wednesday for the duration.
It is not to late to enrol and became part of the already large class.
Learn about MMT properly with lots of videos, discussion, and more.
This year there will be some live interactive events offered to participants, which adds to the material presented previously.
So even if you completed the course last year, these live events might be a reason for doing it again.
If you want to do the course, get in early as then you avoid having to catch up.
All are welcome.
That is enough for today!
(c) Copyright 2022 William Mitchell. All Rights Reserved.