Public investment can stimulate economic growth

Thursday, 30 June 2016 12:30
UPD:12:30
REUTERS/WOLFGANG RATTAY

Public investments into R&D can particularly improve the path of long run economic growth. In Greece these expenditures amount only to 0.4 percent of GDP, far below the euro area average.

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By Christian Dreger
Research Director for Ιnternational Εconomics
DIW Berlin

The Stability and Growth Pact defines upper ceilings for public debt that are often seen as a precondition for higher and sustainable output growth in the euro area. According to the pact, annual budget deficits should not exceed 3 percent, and debt-to-output ratios should be below 60 percent. If these limits are not met, corrective actions and even economic sanctions can be implemented.

While the pact was initially routinely broken and watered down, particularly at the request of the large euro area member states before the crisis, it has become more stringent since then to restore confidence in financial markets. To foster the sustainability of public finances, austerity measures have been implemented. They are part of the restructuring process, particularly within countries in emergency. Several euro area countries like Greece were unable to finance their debt or bail out over-indebted banks under their supervision without supranational assistance. Greece receives conditional support from the European Stabilization Mechanism in exchange for the implementation of structural reforms and progress in the consolidation of public finances.

While fiscal austerity might be beneficial to foster economic growth in the long term, the impacts are often negative in the short term perspective. The consolidation of public finances through a reduction of fiscal expenditures and an increase in taxes depresses the economy in many countries. Unemployment rates exceed 25 percent in Greece and Spain, and unemployment among the youth is even much higher. Due to the fact that the recovery has been only modest so far, the job crisis can persist for many years, and long term unemployment is on the rise.

Public investment is among the candidates to reduce public spending. Cuts in investment are usually easier to implement than is a cut in social transfers. While the share of public investment exceeded 12 percent of government spending before the crisis in Greece, it dropped by more than half over the recent years. The huge fall may be exaggerated due to privatization efforts, but the overall tendency is striking.

This is a critical evolution, as public investment plays a crucial role for the economy. For instance, public investment creates more favorable conditions for private businesses by providing better infrastructure. The existence of facilities and of common public goods can raise the productivity of private investment, which can take advantage of improved business conditions. Public investment in energy, telecommunications, or other network industries have stimulated private investment in the past.

For an economy like Greece, a net increase in public investment expenditures cannot be seen as a feasible option, as the debt-to-output ratio is almost at 180 percent and largely unsustainable. However, the lack of public capital is a common phenomenon in the euro area and most striking for large member states like Germany. Hence, low public investment might have restricted private investment and output growth in the monetary union. Hence, fiscal reforms are needed to foster the positive role of public investment for economic growth. Excluding national co-funding of investment from the fiscal indicators covered by the Stability and Growth Pact can be a sensible strategy to improve the investment performance and overall economic development.

The European Semester, created to better monitor the fiscal planning for individual countries, should encourage higher investment activities in the member states, most notably in countries with public investment below the average. Public investments into R&D can particularly improve the path of long run economic growth. In Greece these expenditures amount only to 0.4 percent of GDP, far below the euro area average. Besides the stimulating effects of higher public investment, preferrable in R&D, governments should speed up their implementation of structural reforms in order to improve the conditions for private activities in labour and product markets. Despite the aim to constitute an area of high and socially inclusive economic growth, the actual performance of the euro area did not met the expectations so far. Convincing strategies are required to overcome the crisis and achieve a path of stronger economic growth in the future.

*This article is part of a feature regarding the Greek crisis, within the context of a cooperation between "Naftemporiki" and "DIW Berlin". It is based on the research "The Greek crisis: A Greek tragedy?" and expresses the personal opinion of the author.

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