The importance of the multiplier effect

Since the onset of the financial crisis four-and-a-half years ago, many countries in the Eurozone – particularly those in the Southern periphery – have been under immense political pressure to improve their fiscal position. Yet austerity measures are failing to bring the expected sustainable consolidation of public finances – resulting in many eurozone countries being forced to consider alternative policies to try and generate growth to ease their respective debt burdens. Meanwhile, infrastructure investment is gaining traction as a potential route out of the mire.

Through our research, we believe that infrastructure investment has a substantial and positive effect on the economic performance of euro area countries. Indeed, such a form of public spending would be ideal as a policy lever throughout the Eurozone.

Certainly, budgetary constraints continue to be extremely tight across the region – and that applies to sovereigns as well as traditional lenders. Indeed, with many banks in Europe still facing capital and liquidity constraints, hindering their ability to provide long-term project finance, it has become necessary for policymakers to consider stimulating economic growth via infrastructure funding.

That said, governments face their own battles with debt. Because of their fiscal situations, governments are therefore keen to ensure value-for-money with respect to public spending. As a result, such spending should be focused on sectors proven to have the highest ‘multiplier’ effect (and by ‘multiplier’, we mean the ratio of the initial change in spending to the total change in the ensuing activity) – of which infrastructure offers the clearest gain.

As our analysis shows, if eurozone countries were to embark on a programme of public infrastructure investment, the benefits – particularly in today’s tough economic climate – are vast, and potentially give these countries the greatest chance yet for recovery. 

OUR RESEARCH MODEL

To reach such a conclusion, we constructed a vector autoregressive (VAR) model, which comprised four variables: output, employment, private investment and public infrastructure spending – all obtained from Eurostat’s national accounts database throughout the period Q1 1995 to Q4 2011. For the sake of simplicity, we considered the EMU-4 countries of France, Germany, Italy and Spain – the largest economies in the euro area. We found that whenever there was an increase in public infrastructure investment in any of these countries, the trend was associated with an increase in the other three variables (output, private investment and employment), particularly in the quarters following an expenditure shock.

If public spending in the infrastructure sector was to become a key policy for these countries, the subsequent boost to the economy would not only be temporary. In Italy and Spain, the benefits of such investment (an increase in output, for instance, implying higher tax revenue over time) could last up to 12 years. When we compared this response to the other EMU-4 countries, it revealed dynamic differences – with Germany and France potentially experiencing the positive effects for only a relatively short-lived period (perhaps just five years).

Therefore, it seems the benefits last twice as long in less developed economies as in highly mature economies, suggesting that investment in infrastructure not only drives a positive demand shock, but also raises factor productivity. In addition, the ‘output elasticity’ proved equally impressive. Under our model, a one percent increase in government infrastructure investment could result in a 0.17 percent increase in GDP in the long-term, and of 0.11 percent within a year.

THE EUROZONE'S 'INFRASTRUCTURE MULTIPLIER'

Certainly, an increase in output is an excellent indicator for the effects of public infrastructure investment. But a key concern for policymakers is the ‘infrastructure multiplier’ – as previously mentioned.

We multiplied the average change in output across the region in response to the public infrastructure spending shock (normalised to 1 percent with the average ratio of GDP-to-public infrastructure investment). In doing so, we obtained an infrastructure multiplier of 14.

This means that for every €1 invested in transportation infrastructure in the EMU-4, it raises the GDP level on impact by €14.

Additionally, as higher output implies higher tax revenue over time, the existence of such a large infrastructure multiplier for the euro area suggests that infrastructure investment is likely to pay for itself.

Clearly, this kind of investment will have positive effects on the economic performance of euro area countries. 

So is public investment in infrastructure the key to Europe’s deficit crises?

As a final test, we wanted to see whether spending in the infrastructure sector has an additional impact during recessionary periods. And, indeed, using a specific formula (including a dummy variable that represents when the economy is running below its long-term capacity utilisation rate), we found that infrastructure investment has a higher impact on activity in bad economic times than in normal economic times.

Of course, as we found significant results only for France, one has to be careful with drawing a general conclusion from such an exercise.

For France, we can report that the direct effect of infrastructure investment on output should result in a positive impact approximately four times larger in worse economic times than in more stable periods, which is something to keep in mind in today’s recessionary environment.

Indeed, as our analysis shows, infrastructure investment is an excellent policy option for many countries in the eurozone, particularly as it generates high return on investments, playing right into governments’ wish to ensure value-for-money. Across Europe, such investment in the sector will also help reduce the public debt burden and augment GDP – making it highly recommendable, we think, as a policy lever, and particularly so because of the post-crisis financial environment.

*Johannes Gareis is an economist at Natixis, and Sylvain Broyer is deputy chief economist at Natixis