Economy - Low levels of public investment, if maintained over a prolonged period, may lead to a deterioration of public capital and diminish longer-term output. - Working Paper - ECB

Publication - The effect of public investment in Europe: a model-based assessment

Since the start of the global financial crisis, public investment has fallen in a number of countries, particularly those that experienced market pressure. Low levels of public investment, if maintained over a prolonged period, may lead to a deterioration of public capital and diminish longer-term output. 

The fall in public investment and the current low interest rate environment have prompted calls to stimulate public investment spending as a way to increase short-term demand and raise potential output (see e.g. IMF (2014)). In the European Union (EU), this has led to the adoption of the Investment Plan for Europe (2015), the so-called “Juncker plan”. The latter aims to stimulate infrastructure and other public investments through combining first-risk guarantees for private sector participation, increasing information on viable projects, and improving the investment climate. The fiscal positions of many EU countries remain fragile, however, and the provisions of the Stability and Growth Pact call for further fiscal consolidation in many of them. In this regard, it seems to be prudent to take a closer look at the relationship between public investment and economic growth as well as budgetary implications of the proposed policy.

Against this background, this paper investigates economic effects of public capital and investment utilising both structural and non-structural model-based illustrative simulations. First, using the methodology proposed by Kamps (2006) for updating a dataset for twelve EU countries, the paper reports new VAR-based estimates of the output effects of an increase in public capital stock.1 Similar to Kamps (2005), we find that, for most of the countries included in the sample, the long-run impact of a shock from public capital on GDP is estimated to be positive, i.e. public capital enhances the production capacity, but not necessarily differently than before the crisis. 

Second, to gain further insights in the economic effects of an increase in public investment on output and public finances, the paper discusses simulations of a temporary but sustained increase in public investment, based on the EAGLE model – a multi-country dynamic general equilibrium model (Gomes et al., 2010). An increase in public investment is found to increase output both in the short term (demand effect) and long term (supply effect), with only a moderate increase in government debt or even a decrease if financed by revenue increases or other expenditure cuts. However, the debt increases considerably more in cases when the existing public capital stock is already high, the productivity of public capital is low or the efficiency of investment (e.g. through waste or corruption) is low. The effects are also sensitive to the monetary policy stance and cross-border spill-overs also matter.

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