Capacity constraints and borrowing to spend

Over at the Standard, Steve Pierson raises the fair point that borrowing to “spend” at the moment is likely to increase inflationary pressures – as capacity in the economy is limited. He uses this idea as a criticism of Nationals “borrow to fund infrastructure policy”.

As a purely demand story this makes sense – however we have to keep in mind where the spending is going, and what it is doing. If funds are being spent reducing capacity constraints by improving truly dilapidated infrastructure, then National is actually right that borrowing to spend on infrastructure will reduce inflationary pressures.

Why? Well by increasing the productive capacity of the economy we increase the size of the “economic pie” that people are trying to trade around. Unless money demand rise 1 for 1 with this increase in productive capacity, then the amount of money flowing around per good will be lower – leading in that sense to lower inflation.

Furthermore, from a wage-price spiral angle, greater productivity will, when wages are sticky, lead to a smaller inflation premium in wage growth. Or it could lower the equilibrium price that firms would want to set. As inflation expectations are a function of previous inflation, a negative shock to prices (which is what happens when we have an increase in aggregate supply) can lower inflationary pressures.

Or another argument may be that labour is a substitute to other inputs – so an increase in infrastructure will lead to less labour utilisation. However, this argument is a bit of a crock isn’t it 😛

The best argument is that “bottlenecks” in the production process increase costs all down the line, thereby leading to the imposition of market power by certain groups and therefore more cost pass through and greater vulnerability to inflation. Of course in such a case we have to ask “where is this happening” and “who is setting these prices” – currently it appears to be in the labour market and government!

Of course, there are conditions that have to be met for this type of infrastructural investment to make sense – but I don’t think we can definitively call government investment inflationary.

If we are going to discuss capacity constraints I think the primary issue is currently skills shortages rather than physical infrastructural issues – as a result, I’m not convinced this is the right tack (especially given the lack of specific information surrounding infrastructural investment projects).

Conclusion

As a result, the important issues are “where do we need infrastructural investment” and “what sort of increases in national productive capacity will stem from this”. Hopefully this information will be provided over the election campaign, and then we can move away from slogans and towards some more objective analysis of policy 😉

Update: After having a think about it I think I should be clear about something here. In this post I dealt with inflation in the true, persistent, sense. In the demand side story I think Steve is putting forward the issue isn’t really inflation – it is whether the spending will lead to an increase in aggregate output or the price level.

Stimulating demand when the economy is tight will push up prices which, absent adaptive (backward looking) expectations, does not imply inflationary pressure will increase – however, it does imply that the change in aggregate output will be highly limited (fundamentally, aggregate supply is more inelastic when capacity pressure are rife).

If the investment instead increases supply itself, then we bypass this issue – which is why the question of how the investment influences the natural rate of output in the economy is such as important one.

In this argument, the idea of “inflation” is a second order concern – as long as the central bank will change interest rates to restrain inflation, then outside of the “cost” of higher interest rates the inflation issue is not especially relevant.

As a result, this is another way of saying that, if the investment is in good things, it could work – if the investment is in trash, or is overpriced, then we shouldn’t be doing it. So for goodness sake – lets not invest in infrastructure without some objective analysis of the costs and benefits of this investment.