June 11, 2018

Investment spending and European Deficit rules

One of the iron laws of Italian politics is that every new government promises more spending in infrastructure; and ask the EU to change its rules by not counting infrastructure spending for the calculation of the deficit. This is indeed an important demand, which needs to get a fair hearing.

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One of the iron laws of Italian politics is that every new government promises more spending in infrastructure; and ask the EU to change its rules by not counting infrastructure spending for the calculation of the deficit.  This is indeed an important demand, which needs to get a fair hearing.  One supporting argument is that the constitutions of some countries, including that of Germany in the past, often incorporate a similar rule, namely that deficits are acceptable if they are due to infrastructure spending.

At first sight, this ‘golden rule’ as it is often called, can be based on a strong argument: it seems reasonable to finance investment by debt because this debt can be served by the higher taxes that come when GDP increases because of the better infrastructure.  However, this simple reasoning is wrong because it hides one key detail, namely the difference between gross and net investment.  The argument that government infrastructure spending could be financed by debt assumes implicitly that every euro of this spending creates new capital.  But this is not the case, by far. Mature economies already have a large stock of capital. All these roads, airports, railway lines, bridges, etc. need to maintained in good operating state.  Existing capital thus needs continuous expenditure just to maintain its value.  Economists capture this by distinguishing between net and gross capital formation.  Gross capital formation is what the government spends on infrastructure, which includes both maintenance and new projects. The net concept shows by how much the capital stock has actually increased because new roads, bridges, etc. were created.

Residents of Brussels woke up to the importance of continuous maintenance when they discovered that the local government had over decades neglected to main the bridges and tunnels of the Capital of Europe.  When these essential elements of the city’s infrastructure started to become unusable because of cracks and water infiltration they became unserviceable and now have to be rebuilt at great expenditure.  But this repair work does not create new value, it just restores the value of what had been built in the past.

It follows that the ‘golden rule’ should say that it is acceptable to finance only net capital formation by debt.  Additional debt is justified only if the government builds new roads or bridges (while keeping the existing ones in good shape).  In young fast growing economies the difference between net and gross capital formation might not matter that much because the initial capital stock is small, implying that little needs to be spend to offset depreciation. But this is different in slow growing mature economies.

In mature economies, most infrastructure spending is in reality needed just to maintain the existing capital stock.  This is also the case in Italy.  Already before the crises, a very large share of spending on infrastructure spending was really maintenance, needed just to offset natural depreciation, as can be seen from figure 1 which is based on Eurostat numbers.

Even worse, over the last years, government spending on infrastructure spending has fallen so much that the public sector capital stock has actually stared to decline.  In other words, net investment spending has become negative since 2013! This has one key implication: If one were to apply the rule that the fiscal deficit under the Stability Pact should be adjusted for net investment spending, the limit would have been much lower than 3 % of GDP for Italy

Gros figure 1

Source: AMECO, 2018

 

The right hand panel of figure 1 shows the trends for Germany, where infrastructure spending has been more stable (as a % of GDP).  But the level has been n so low that the existing stock has fallen in disrepair. A few ago it was discovered that almost all bridges over the country’s Autobahns had not been properly maintained, requiring an expensive crash program to prevent them from collapsing. The famous ‘black zero’ is thus partially an illusion.

For Italy the consequence of looking a net investment figures would be stark. Expenditure on infrastructure (also called gross fixed capital formation) is running at around 33 billion euro (based on 2017 figures).  But the dream of the Italian government have this sum exempted from the calculation under the deficit rules of the Stability Pact seem totally misplaced since ‘consumption’ of fixed capital (i.e. infrastructure) is running at about 44 billion (per annum),  The Italian public sector is at present running down the infrastructure to the tune of about 11 billion euro.  The deficit taking into account this disinvestment should thus be increased by this number.

Even under the most optimistic scenario that the rules of the Stability Pact are changed, Italy could gain any leeway to run larger deficits only if infrastructure spending were to be increased by at least 11 billion euro (per annum).

 

The author

Daniel Gros

Daniel Gros is Director of the Centre for European Policy Studies (CEPS), Senior Fellow of LUISS School of European Political Economy and Member of the Advisory Board of The LUISS Center of Italian Mezzogiorno Studies


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