Public Capital - Economic Growth

Economic Growth

One of the most classic macroeconomic inquiries is the effect of public capital investment on economic growth. While many analysts debate the magnitude, evidence has shown a statistically significant positive relationship between infrastructure investment and economic performance. U.S. Federal Reserve economist David Alan Aschauer asserted an increase of the public capital stock by 1% would result in an increase of the total factor productivity by 0.4%. Aschauer argues that the golden age of the 1950s and 1960s were partly due to the post-World War II substantial investment in core infrastructure (highways, mass transit, airports, water systems, electric/gas facilities). Conversely, the drop of U.S. productivity growth in the 1970s and 1980s was in response to the decrease of continual public capital investment and not the decline of technological innovation. Likewise, the European Union nations have declined public capital investment through the same years, also witnessing declining productivity growth rates. A similar situation emerges in developing nations. Analyzing OECD and non-OECD countries’ real-GDP growth rates from 1960-2000 with public capital as an explanatory variable (not using public investment rates), Arslanalp, Borhorst, Gupta, and Sze (2010) show that increases in the public capital stock does correlate with increases in growth. However, this relationship depends on initial levels of public capital and income levels for the country. Thus, OECD countries witness a stronger positive link in the short term while non-OECD countries experience a stronger positive link in the long term. Hence, developing countries can benefit from non-concessional foreign borrowing to finance high-prospect public capital investments.

Given this relationship of public capital and productivity, public capital becomes a third input in the standard, neoclassical production function:

where:

Y_t represents real aggregate output of goods and services of the private sector

A_t represents productivity factor or Hicks-Neutral technical change

N_t represents aggregate employment of labor services

K_t represents aggregate stock of nonresidential capital

G_t represents flow of public capital stock (assuming services of public capital are proportional to public capital)

In this form, public capital has a direct influence on productivity as a third variable. Additionally, public capital has an indirect influence on multifactor productivity as it affects the other two inputs of labor and private capital. Despite this unique nature, public capital investment, used in the production process of nearly every sector, is not sufficient on its own to generate sustained economic growth. Thus, rather than the ends, public capital is the means. That is, instead of being seen as intermediate goods used as resources by businesses, public capital should be seen as goods which are used to make the final goods and services to consumers-taxpayers. Nevertheless, high public capital investment usually leads to crowding out effects for private investment. Similarly, public capital levels should not be too high that it leads to financing costs and high tax rates issues which will negate the positive benefits of such investments. Moreover, infrastructure services carry the market-distorting features of pure, non-rival public goods; network externalities; natural monopolies; and the common resource problem such as congestion and overuse.

Empirical models that attempt to estimate the public investment and economic growth link involve a wide variety including: the Cobb-Douglas production function; a behavioral approach cost/profit function which includes public capital stock; Vector Auto Regression (VAR) models; and government investment growth regressions. These models nonetheless contend with reverse causality, heterogeneity, endogeneity, and nonlinearities in trying to capture the public capital and economic growth link. New Keynesian models, though, analyze the effect of government spending through the supply side rather than traditional Keynesian models that analyzes it through the demand side. Therefore, a temporary surge of infrastructure investment yields an expansion of output, and vice versa that dwindling infrastructure, like in the 1970s, hamper longer-term movement in productivity. Furthermore, new research on regional growth (as opposed to national growth with GDP) shows a strong positive relationship between public capital and productivity. Both fixed costs and transport costs lower with expanded infrastructure in localities and the resulting cluster of industries. As a result, economic activity grows along its pattern of trade. Therefore, the importance of regional clusters and metropolitan economies comes into effect.