How to prioritise public infrastructure investments

More of the same in 2016

The global economy is facing a growth challenge. In our main scenario for this year, we project global GDP to grow at a similar rate as last year, around 2.5-3%. Figure 4 shows that this will be the fifth consecutive year of below trend growth when measured in MER terms (this is less pronounced when measured in PPP terms as more prominence is given to emerging markets). There are many possible ways to try to boost growth but one option that is often recommended is to accelerate public investment in infrastructure. Recently, for example, Christine Lagarde, head of the IMF, said that “investing in badly-needed, but well-designed, infrastructure is an obvious area of great potential”.

Global GDP growth is expected to be below its long-term trend again in 2016

Infrastructure investment boosts short-term demand and long-term supply

In the short-term, building or upgrading transport or energy networks, for example, can boost aggregate demand through increased construction activity and employment. In the long-term, infrastructure investment can boost economic growth by increasing the potential supply capacity of an economy. For example, improving transport facilities could make workers more mobile, so making labour markets more efficient and increasing productivity. While there are a number of other factors which influence labour productivity, including skills and technology, Figure 5 shows that there is a strong positive correlation between the quality of physical infrastructure and labour productivity in the G7 and the E7. 

Correlation coefficient between labour productivity and overall infrastructure quality is 0.81

The long-term benefits of infrastructure investment are supported by the literature. For example, there are estimates that one extra dollar spent on infrastructure in Canada could increase GDP by between $2.46 and $3.83 in the long-term, discounted to present value terms.1 But this money does need to be spent effectively to realise these gains.

Principles for prioritising infrastructure investments 

Policymakers are constantly wrestling with decisions on how to prioritise and allocate infrastructure funds. Based on our experience of working on infrastructure projects, we have set out four principles to help their decision making process. These are applicable across all stages of the economic cycle, whether policymakers are planning to invest more, or when spending must be reined in as government finances come under pressure. Our principles are as follows:

1. Ensure it meets a need – This can be done by identifying current and future needs. The former could be by analysing usage data, or through surveys. However, future needs are generally a more important consideration and hard to estimate. A standard approach is to project forward demand, but there is some evidence that these projections could be subject to optimism bias e.g. Flyvbjerg (2008).2 Ideally, a range of scenarios including optimistic and pessimistic cases should supplement the base case analysis. 

2. Ensure consistency with other objectives – Infrastructure projects should fit with the government’s broader policy agenda, including social and environmental as well as economic goals. For example, in the UK, the Government’s commitment to invest £13 billion in transport in the North of England is consistent with its objective to develop a ‘Northern Powerhouse’. Or in the case of Canada, building stronger communities and cities by renewing attention on public transit and green infrastructure.

3. Ensure the numbers add up – Successful infrastructure projects need to be financially viable. This includes making sure funds are available to finance the project, but at present this does not seem like a major constraint as Figure 6 shows that long-term government bond yields are trading well below their historical average rates across the G7. For governments with a relatively low net debt position and healthy public finances (e.g. Germany and Canada), embarking on an infrastructure-led programme seems like a sensible way to boost aggregate demand and long-term supply capacity. But even where budget deficits remain relatively high, as in the UK, there could be a case for prioritising infrastructure investment over current spending.   

4. Ensure it will benefit the wider economy – all of the potential impacts of an infrastructure project should be considered. The assessment should factor in both the long-term effects as well as the direct and indirect impacts relative to a scenario where the project does not go ahead.

Long-term government bond yields are below their historical average in every G7 economy

Good investment decisions could boost the global economy

In response to the Great Depression in the 1930s, the US enacted the Public Works Administration, investing $6 billion in infrastructure over a number of years (equivalent to around 11% of US GDP in 1933, the year the PWA was established) to kick start growth and productivity. This type of investment is once again being touted as the key to unlock our low growth environment – but  the effectiveness of this policy will ultimately depend on how many shovel-ready projects in different economies meet the four principles outlined above.

1“The Economic Benefits of Public Infrastructure Spending in Canada”, The Centre for Spatial Economics (2015)

2“Curbing Optimism Bias and Strategic Misrepresentation in Planning: Reference Class Forecasting in Practice”, Flyvbjerg (2008)