Reframing the multiplier effect

Boosting competitiveness, creating jobs and fuelling economic growth are some of the arguments used to make the case for increased spending on infrastructure projects. The multiplier effect, which is an increase in income generated by an increase in spending, is part of that conversation. While the actual estimates can vary from around 1.4 (meaning for every dollar spent, 40 cents will be added to gross domestic product) to 2.5 depending on who is conducting the analysis and for which market, disputing the effect altogether doesn’t seem reasonable.

Yet a recent article in the Wall Street Journal did just that, citing a paper published by Andrew Warren, an economist for the International Monetary Fund (IMF). According to Warren’s study, which focused on low-income economies, there was “very little” evidence that major public investment drives have served to promote or accelerate national economic growth.

However, before jumping to any sweeping conclusions, it is worth noting that in the case of Bolivia, Mexico and the Philippines – countries which had public investment booms and were included in the study – there was no evidence that projects were selected on the basis of sound economic criteria. Cost and price forecasts were over-optimistic, and public investment programmes were vulnerable to abuse.

Research firm BMI also conducted a relevant study a little over a year ago. That study focused on the impact of infrastructure investment on the construction sector specifically in three developed markets.

After examining the effects of the American Recovery and Investment Act in the US, the National Infrastructure Plan in the UK and the Railway Plan in France as they were implemented from 2009 onwards, BMI did not find a significant uptick in construction activity.

“On the contrary, in the UK and in the US we’ve seen the construction sector pick up very much on the back of the housing market,” BMI’s head of energy and infrastructure research Marina Petroleka told Infrastructure Investor.

Does this mean that the multiplier effect is no longer a valid argument in support of infrastructure investment?

It seems unlikely and, as Petroleka pointed out, “I think in the developed market, it would very much depend on how the money was spent.”

The same can also be said of emerging markets. Therefore the question is not whether public spending on infrastructure has a multiplier effect but rather what is the multiplier effect of “wise” infrastructure investment; “wise” meaning projects that fill a need of the community they serve and which are economically viable.

“Actually, the projects that have a lot of private capital behind them would have the biggest impact because more often than not they won’t be a road to nowhere,” Petroleka remarked. “In a sense, what you get by involving the private sector is an additional layer of risk assessment to the project and an additional viability analysis.”

Warner told the WSJ that “when you flip the infrastructure switch, the light doesn’t necessarily turn on.” But there are plenty of dissenting voices.

Last October, the IMF claimed that increasing spending on public infrastructure would raise output in the short term by bolstering aggregate demand and in the long term by raising aggregate supply. In most advanced economies, the organisation estimated that every incremental dollar invested in infrastructure had the potential to add 40 cents to GDP in the first year and $1.50 four years after the initial spending increase.

‘Clear benefits’

More recently, Standard & Poor’s said it saw clear economic benefits to G20 countries increasing public spending on infrastructure. In its January 21, 2015 issue of CreditWeek, S&P estimated that an increase in spending of one percent of real GDP could result in a multiplier effect as high as 2.5 in a three-year period (2015-2017). Using Oxford Economics’ Global Economic Model, the ratings agency estimated a multiplier of 2.5 for the UK, 1.7 for the US, 1.4 for the Eurozone, 1.0 for Australia and 2.2 for China.

Economic models aside, it is clear that modern and well-functioning infrastructure is vital to a country’s competitiveness. As many observers have pointed out, the US’ ability to maintain a competitive edge throughout most of the 20th century was in large part due to its excellent infrastructure. It’s no coincidence then that as the country’s infrastructure deteriorates so has its competitiveness ranking. By improving competitiveness – something infrastructure can do – a country is able to attract investment, create jobs and grow its economy. That’s the multiplier effect.