Blog post

The impact of government spending

Dr Nicholas Apergis, former professor of economics at the University of Derby, assesses the impact of such fiscal spending deficit on the UK economy.

By Nicholas Apergis - 26 November 2020

Yesterday (25 November 2020), the Chancellor of the Exchequer promised the UK government would spend billions of pounds to help tackle Covid-19 next year. Through increased funding it will deliver stronger public services and improve infrastructure to drive the country out of the recession zone and to support new jobs. The Chancellor claimed that the government’s immediate priority was to protect people’s lives and livelihoods as the country continues to battle the outbreak.

Infrastructure spending and the UK economy

In UK policymaking, in recent years, there has been recurrent calls to increase spending on public services and mostly infrastructure investments. Due to the recent pandemic crisis and the uncertainty associated with Brexit, this is expected to deliver positive effects as increased infrastructure investments could go a long way to solving several pressing challenges that the UK economy has to cope with.

In the very short-term, the most pressing economic challenge for the UK economy remains Brexit and the possible associated unemployment consequences. The longer-term economic challenges concern how to provide satisfactory living standards growth for UK households. Such growth requires two components: rapid overall productivity growth, and a stabilisation (or even reversal) of the large rise in income inequality that the economy faces — a rise that kept the overall productivity growth from translating into living standards growth for most of these households.

Is there enough slack in the economy?

Because the impact of infrastructure investments on the overall level of economic activity depends on the degree of productive slack in the economy, the stance of monetary policy, and how overall investments are financed, it is impossible to reliably forecast the long-term effects of such investments on the overall level of economic activity. However, we can reliably project the impact of infrastructure investments on the composition of labour demand. Even if these investments crowd out other forms of public or even private spending (i.e. the crowding-out effect) and do not affect the overall level of activity and employment, it remains the case that the composition of employment supported by additional spending on infrastructure would be different than that of the economic activity it potentially displaces.

Our position conforms with a large and growing body of research, persuasively arguing that infrastructure investments can boost even private-sector productivity growth. An ambitious effort to increase infrastructure investment would likely increase productivity growth (especially if such investments are targeting the IT sector). Such a productivity acceleration is expected to have measurable impacts on the estimated Non-Accelerating Inflation Rate of Unemployment (NAIRU) and could allow macroeconomic policymakers to target significantly lower rates of unemployment.

Moreover, policymakers should address the need for the country to transition to an economy that emits fewer greenhouse gases. They could package up a mix of investments in energy efficiency across many sectors in the economy. This is the hypothesis of the ‘stabilisation wedge’ of pollutant emissions abatement, according to which the mitigation of carbon emissions is nothing else but a benchmark for reducing the future costs imposed by climate change.

In addition, state-financed infrastructure projects also lean heavily toward the manufacturing sector, with transportation equipment (such as, aerospace, ships and boats, and motor vehicle manufacturing) dominating. The high shares of aerospace and shipbuilding could also be driven, in part, by the fact that defence spending accounts for a substantial share of total public investment as the Prime Minister recently announced.

In terms of projecting and assessing the near-term, net employment impacts of increased infrastructure spending, a number of hypotheses must be specified. How much economic slack exists, particularly in labour markets? How will monetary policy authorities likely respond to a macroeconomically significant increase in infrastructure investments? And finally, how will the infrastructure investments be financed? Through public debt? Through increased revenues? Or through private borrowing or retained earnings?

Provided that there is a large amount of overall economic slack in the UK economy today, while monetary policymakers are highly unlikely to try to neutralise demand increases stemming from near-term infrastructure investments, the most natural assumption for how they would be financed is simply through new government debt. This would allow the investments to have the largest impact on near-term economic activity and employment.

Spending power

However, due to the accommodating character of the Bank of England monetary policy, this extended public deficit and debt is not going to incur any increase in interest rates that usually offset some of the positive results associated with higher public spending, while they appreciate the pound and discourage exports activity. In addition, inflation arising from increased spending would actually be helpful in spurring economic recovery and could well lead to faster growth in other sectors of the economy, given the very extraordinary circumstances in the current UK economy.

The argument that a higher price level is expected to reduce the real purchasing power of fixed nominal wealth and reduce aggregate demand, seems to be offset by the argument that a higher price level also decreases the real burden of debt, not just wealth. If the propensity to consume out of current debt is higher than the propensity to consume out of current wealth, then a higher price level, by effectively re-distributing purchasing power from lenders to debtors, can actually raise aggregate demand. Therefore, even if increased infrastructure spending somehow pushes up domestic prices, it is highly unlikely that this would reduce spending growth in other sectors of the economy.

Potential to boost growth

In the short-term, infrastructure spending, particularly if deficit-financed, is routinely found to be among the most effective tools in pushing the economy back towards full employment. In the longer-term, it is also expected to generate positive spillovers through more fair shares of overall productivity growth across households. The Chancellor’s programme will achieve not just that, but also it can ensure access to high-quality jobs for traditionally disadvantaged segments of the labour market, i.e. females, minorities, and young workers if such spending focuses on IT investments and fighting climate change. Overall, such types of investments can yield large economic returns and carry the potential to boost productivity growth.

For further information contact the Corporate Communications team at pressoffice@derby.ac.uk or call 01332 593419.

About the author

Nicholas wearing a shirt and a University of Derby staff lanyard.

Nicholas Apergis
Former Research Professor of Economics

Nicholas supported and enhanced the research profile of the department either through individual or joint research efforts.