Debt for infrastructure – and the issue is?

There has been a lot of talk (here, here, here, here, here, and here) about the a potential National government taking on debt for infrastructural investment. Now I’ve got no problem with this, and Roger J Kerr says here we could view it as an intergenerational issue – borrowing allows us the stagger the cost of the capital over time in the same way that the benefits from the capital investment occur over time.

Furthermore, borrowing allows us to fund expenditure that provides economic growth, without having to introduce taxes that limit this growth (although note that future taxes would have to be higher to pay for the borrowing – so we only have a net benefit if growth stemming from the capital investment exceeds the cost of the eventual tax increase!).

However, there are a couple of issue that I hope any government will remember before going into debt to build up infrastructure.

  1. Only the “right sort” of investment will be beneficial. Fundamentally, the rate of return must be high enough to justify the debt AND the government must be aware of how their investment activity will crowd out private investment.
  2. Ultimately the tax system still has to be balanced over the economic cycle.

Right sort of investment?

One of the difficulties with government investment is that they don’t see the price signals associated with the optimal level of investment, in the same way that private firms do. As a result, government’s have the propensity to over or under invest, depending on the often fluffy goals that they lay down.

However, the advantage of government investment stems from their ability to improve outcomes when we have a “public good“. As private firms will underinvest in the case of public goods, then the degree of “crowding out” associated with government action is lower (it solely relies on the impact that government involvement has on the price of building inputs). So as long as the rate of return on this investment is high enough to pay for the debt, this is fine.

Balanced tax system?

A balanced tax system is a set of taxes where the government runs a balanced budget over each individual “economic cycle”. This does not mean that the government will always run a balanced budget – in fact, when output is above trend the government should run a surplus, and when it is below trend it should run a deficit. In this (demand driven) view of the economic cycle a surplus or deficit are not an issue – as long as it all balances in the end.

This implies that the government in power needs to realise that there is no free lunch – the debt will need to be paid off in the future. If we are truly borrowing for infrastructure that is fine (given that our first requirement holds), however if we will have to, on average, borrow because spending exceeds taxes, then something has to give!

Another way of viewing a balanced budget is through the lens of supply side shocks. In this case there is no real economic cycle, just a random assortment of supply shocks that give the appearance of a cycle. Here, the positive supply side shocks cause surpluses while the negative ones cause deficits and the tax system does need to adjust to put things back in order. However, from the current standpoint, we do not know whether there will be positive or negative supply shocks in the future, so the best thing to have is a balanced budget.

In truth it is a mix of the demand and supply stories that describes reality – implying that the tax system should remain stable over time, until a sufficiently number of supply shocks force us to move. In a sense this is what Dr Cullen did (although he was effectively increasing taxes by not indexing the them to inflation – thereby breaking this rule!), given the level of expenditure that he wanted to put into place.

As long as National takes this lesson to heart as well then I am sure that no matter which party wins the election, the government finances will remain in good order.

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  • I think a big issue in the infrastructure debate is the funding mechanism. I would love to see easily accessible and quality infrastructure bonds or sem-government debt that Mums and Dads could invest in …. instead of some of the riskier options chosen over the last 5 years that invested in residential property.
    I think there’s a case for a single local government bond issuance vehicle to fund this NZ$30 bln of local infrastructure needed over the next decade.

  • Hi Bernard,

    Didn’t Mum and Dad investors have the implicit opportunity to get involved with private investment by buying stocks or simply putting their money in the bank. If we are going to work on infrastructure it would be nice to fund some of it domestically – but given current the revealed choices of New Zealand households I’m not entirely sure that we would see these picked up (and if we did it may well be to the determent of productive private investment).;

    I agree that there is an information problem, such that the risks associated with different kinds of investments (namely residential property and finance companies) were underplayed, however the best way to solve that would be to increase the transparency surround risk and also to educate people about risks.

    Ultimately, the debate on infrastructure should be focused on whether we get a sufficient social return from the thing in the first place.

  • My only caution on balanced budgets over the cycle: careful that you don’t word the rules such that budgets need only be balanced on average over the medium term. We know where that leads.

  • “My only caution on balanced budgets over the cycle: careful that you don’t word the rules such that budgets need only be balanced on average over the medium term”

    😀

    Indeed, a balanced budget over time does not imply that the budget only needs to be balanced for one quarter over the next five years 😛

  • Kimble

    I agree with BH about it being nice if we could get some higher quality debt offerings in NZ. Something which pays a slight premium above government stock, is very liquid, and that has a very long duration. It would really help with retirement planning.

  • “I agree with BH about it being nice if we could get some higher quality debt offerings in NZ”

    Ok, but I don’t see why this should be a fundamental issue for deciding if the government should take on debt to borrow – it is a secondary issue about how to best raise the funds.

    If there was sufficient demand for such an asset on the private side of the economy, it would have been created – so I’m not even entirely convinced that such an instrument is “necessary”.

    I certainly would not support government borrowing for “investment” if the sole goal was the creation of a debt instrument for people to put their money with – the actual quality of the investment should be the primary issue.

  • CPW

    Although I agree with you Matt, I would be tempted to describe some sectors of the NZ debt market as suffering from large amounts of market failure (brought about by information asymmetry). Better informed investors would have gone nowhere near a lot of finance companies at the rates being offered. So “crowding out” investment from finance companies and into council debt probably would be welfare enhancing for the average investor.

    I believe the stigma of public borrowing may be too high in NZ at the moment, and positive net present value projects never get off the ground. So i would cautiously endorse moves to encourage greater use of borrowing for infrastructure.

    “I am sure that no matter which party wins the election, the government finances will remain in good order.”

    In the sense of compared to the rest of the world, or compared to 15 years ago, the government finances are in good order. But the 2008 budget is projecting cash deficits that lead to a steady increase in net debt (a more relevant metric than gross debt) as a % of GDP, even with the economy back at a steady-state growth rate. So something has to give: higher taxes, less spending growth, or less investment/Cullen fund. It seems unlikely that National’s policies will improve this situation.

  • “So something has to give: higher taxes, less spending growth, or less investment/Cullen fund. It seems unlikely that National’s policies will improve this situation.”

    Agreed – I just wanted to avoid sounding like I favoured one party over the other, since I’m not a fan of any political parties at the present moment.

    You could always do a post on the government financial situation – and what this may imply for the outlook for government spending/revenue 😛

  • Practice has a logic which is not that of the logician.PierreBourdieuPierre Bourdieu, French sociologist

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  • Matt: One major problem with playing with government debt in NZ is people about my age or slightly higher. We’ve just finished paying back debt from the 70’s and 80’s that at its peak was over 60% of our GDP and consumed something like 20%+ of the government revenue.

    That debt was largely put in place because of Think Big projects that didn’t pay off, and a minimum payment system to cope with a ‘temporary’ fluctuation in the price of some agricultural products. The raising of this debt was supposed to help secure the economic position in the future for people like myself who were unable to vote. In one case it was to put in industrial infrastructure, and in the other to maintain a rural infrastructure.

    In reality as far as I’m concerned, both supported inadequately researched projects that made assumptions about future economies that were wishful thinking (even at the time). I’d tend to view them as election bribes because they went into areas that the Nat’s need to win in a FPP election. However I had to help pay for them for the following 30 years when I didn’t even get an opportunity to vote.

    Thats why we are debt adverse in the government. It doesn’t matter the mechanism. The problem is that we do not have a lot of faith in politicians who can shift debt onto future generations. To reduce the risk of pork-barrel politics, as much of debt repayment should be loaded as early as possible. After all if there is a big reason to have a project started earlier than it can be paid for, then the political risk of doing so should be carried by the people starting the project. That is what Cullen and co have been largely doing.

    Now the problem is that we have a party wants to fund projects with debt. Don’t know what projects that they really want to fund. They don’t even give an idea about how they’d decide between projects. They also propose to reduce the time for objections without giving any commitments on when they’d do basic things like give project costings. Costings are likely to be useless anyway because there will be (based on overseas experience) more confidential codicils driving up the costs and risks that are never exposed to public scrutiny.

    To me they look like a party that wants to push costs to future generations and remove political risk until after they are out of office. In other words – the same old national that made me pay interest for essentially useless electoral boondoggles for 30 years.l.

  • “In reality as far as I’m concerned, both supported inadequately researched projects that made assumptions about future economies that were wishful thinking (even at the time)”

    I agree

    “Thats why we are debt adverse in the government. ”

    And that is good – government should be debt averse. However, that does not mean that we should rule out ALL borrowing projects – it simply means that borrow for a project should only occur when a certain rate of return will be made from it that takes account of this risk.

    Ultimately, as long as we have a independent and impartial public service, the costing of these things should be accurate – and as a result it would be a good idea to do some borrowing.

    Thats the catch though isn’t it – we have to trust the costings! Hopefully we can – and hopefully we do find out what projects any government would borrow for.