It’s time for a quick round of everyone’s favourite game, Ask An Economist. Today’s question is: What happens when the government decides to spend up large in a growing economy?
If you guessed that the answer is that it will drive up inflation and crowd out private sector spending, congratulations! You win a hug from the invisible hand. You’ve obviously either paid attention to the lessons of history or the words of latter-day popularisers of economic theory such as Bill English, who recently said that:
It was also important for the Government to run a counter-cyclical fiscal policy which, right now, meant running surpluses, paying down debt, and limiting future initiatives in spending and tax cuts to what would not push interest rates higher than they need be.
However, the government is acting as though the normal rules of prudent fiscal management don’t apply to the road budget. Instead of taking a conservative approach to transport spending, and focusing on the projects that offer the best long-term value at a relatively low cost, they’re pushing ahead with plans to build a number of expensive road projects. For example, the 2014 Budget announced another $800m in motorway projects in Auckland, paid for in part by borrowing, along with $212m in regional road projects paid for out asset sale proceeds.
As an economist, I’m nervous that the motorway spend-up will have perverse economic effects, driving up prices and crowding out other activity. When I went to look at the data, I found reasons to worry.
First, I looked at the data on New Zealand’s spending on roads (from OECD.Stat). The following graph shows investment in new or improved roads as a share of GDP. Essentially, New Zealand spent a fairly consistent amount on roads – and much less on public transport! – in the 1990s. In 2004, road spending started to increase rapidly, rising from about 0.3% of GDP to 0.7%. Unfortunately, the OECD’s data doesn’t cover the last few years, but NZTA’s data suggest that road infrastructure spending has risen further.
So the government has boosted spending on roads over the last decade. Has this had any impacts on inflation?
I used Statistics NZ data on inflation to examine the effects. The following graph compares the Capital Goods Price Index for civil construction, a measure of construction cost inflation, with the Consumer Price Index, which measures inflation in the general economy. (NZTA uses a slightly different composite measure of road construction prices, but I’ve chosen to look at civil construction prices as they provide a better indication of potential crowding-out effects on private construction.)
As you can see, the CGPI for civil construction tracked closely with CPI from 1995 to 2003, when road spending made up a relatively constant share of GDP. Between 2004, when the road spend-up started, and the Global Financial Crisis in 2008, civil construction prices rose much more rapidly than the CPI. Construction price inflation briefly cooled off in the aftermath of the GFC, due to falling private-sector demand for construction. But over the past two years it has again started rising faster than CPI, as a result of the economic recovery and spending on major road projects such as Waterview.
In short, spending an increasing amount of money building roads has coincided with a big increase in the cost to build roads. This is exactly what most economists, along with the current Finance Minister, would have predicted to happen.
Moreover, this is likely to have a significant negative effect on private construction. If you want to build an apartment building or a warehouse, you’ll have to compete with NZTA for bulldozers, cranes, and construction labour. Expect to pay higher prices as a result. If civil construction prices had continued to rise in line with CPI over the last decade, rather than being bid up by road spending, big construction projects would be almost 20% cheaper than they are now.
To be fair, other factors may have also played a role, such as the run-up in house prices in the 2000s and increased oil prices. But as Bill English says, government spending shouldn’t exacerbate the inflationary pressures that exist in a growing economy.
This is a tricky dilemma for any government. On the one hand, we do need to invest in a transport network that can accommodate future growth in Auckland. On the other hand, it would be better if the government’s spending didn’t create perverse outcomes for the private sector. If it wants to steer clear of the Scylla of underinvestment and the Charybdis of inflation, it would make sense to look at cheaper alternatives – e.g. the Congestion-Free Network.