Tag Archives: economics

Renewing Britain’s infrastructure?

Forget the budget. This week’s most interesting news was David Cameron’s speech on Britain’s infrastructure. While the headlines focused on the possibility of using private companies to help run the UK’s motorways and major trunk roads, the statement was actually much broader and also touched upon the roll-out of high speed broadband, 4G mobile networks, and reforms to the national planning system. The linking theme was that Britain is “falling behind our competitors and […] the great world-beating, pioneering tradition set by those who came before us”. In other words, our Victorian infrastructure legacies are inadeqaute to the needs of the twenty-first century.

This isn’t a problem that’s unique to Britain. In the United States for example, municipalities are struggling to maintain aging water infrastructures where, in some places, the pipes are over a hundred years old and made out of wood. And like in the US, the need for major infrastructure investments raises substantial questions about the role of such facilities and who should pay for it.

In this post, I want to sketch out some thoughts on infrastructure and look at three related questions:

  • Is infrastructure a private or public good?
  • How should it be financed?
  • How do infrastructure investments relate to the wider economy and our prospects for growth?

Is infrastructure a private or public good?

Infrastructure is traditionally viewed as a public good, meaning that people can’t be excluded from its use and one person’s use doesn’t affect its availability to others. This is a somewhat stylised view – think of congestion on a roadway – but the important point is that the alternative view, infrastructure as a private good, would lead to a shortfall of provision. Left to its own devices, the private sector would only build infrastructure that provided a sufficient return on its capital, at commercial terms, and so roads would only be built on routes where there was sufficient toll revenue to justify their construction and similarly energy and communication networks would be built only in areas of high demand.

Governments have historically taken the view that society benefits from providing (near) universal access to these facilities at low or no cost, and hence they have been willing to pay for infrastructure projects with public money. This doesn’t necessarily mean that such investments are uneconomic, because governments are typically able to borrow at lower costs than the private sector and are willing to wait decades for such assets to pay off. And in the meantime, households and businesses benefit from the public provision of these goods. Unfortunately, these borrowings show up on public balance sheets which, in times of economic turmoil, may not be what governments want.

Cameron’s speech recognized the public good nature of infrastructure several times, remarking that these systems are part of a nation’s assets which “sustain future prosperity” and that exclusive private sector provision risks “leaving some people behind”.

How should infrastructure be financed?

One can therefore conclude that infrastructure in the UK is still seen primarily as a public good, but one for which the public purse is increasing reluctant to pay. So what alternatives are available?

Over the past two decades, one of the most popular options in Britain has been public-private partnerships and private finance initiatives in particular. The precise detail of these arrangements can vary significantly from project to project, but the general idea is that government contracts with a private sector firm for the provision of a public good or service. So the M6 toll route for example was built with private funds, in return for the ability to collect tolls over a 53 year period.

Another busy day on the M6. Source: Wikipedia

These arrangements have been widely critized, with a recent Treasury Select Committee describing PFI as an “extremely inefficient” method of financing public sector projects. The simple financial reason for this inefficiency is that “[t]he average cost of capital for a low risk PFI project is over 8%, double that of government gilts”. In other words, the government can borrow money much more cheaply than the private sector. The only problem is that this borrowing ends up on the national balance sheet and chancellors are loath to do this. This sort of short-term thinking is also common in United States, where long-term infrastructure leases are provided to private firms “in exchange for one-off lump sum payments of a few billion bucks at best, usually just to help patch a hole or two in a single budget year.”

Having been criticised by the Treasury Select Committee and by the current chancellor, the political question is how can a PPP deal be structured that doesn’t look like PFI but still delivers new and improved infrastructure without a significant impact on government borrowing figures. The chancellor’s current strategy is to encourage investment from pension funds and sovereign wealth funds, but as the Guardian’s excellent fact check article discusses, the new proposals aren’t substantially different from previous PFI arrangements. And what’s more, new projects won’t magically appear as the UK still faces long-term challenges with the cost of its infrastructure projects (60% higher than in Germany). The proposed planning reforms are intended to help reduce these costs by speeding up the process and removing uncertainty for investors, but whether these changes will be effective is another issue.

Funding infrastructure in tough economic times is clearly a challenge. Public-private partnerships could be a good alternative but the UK experience suggests that these arrangements are very expensive and only have the benefit of deferring large line items to future budgets. However that may be enough for the current government to proceed with PFI Mark 2.

What do infrastructure investments mean for the wider economy?

One of the reasons why infrastructure is in the news at the moment is that constrained capacity in transportation, house building, and communications networks is seen as a barrier to economic growth. Build more capacity and the good times will roll, or so the theory goes.

There are two issues here. The first is the stimulus value of immediate infrastructure investment. If the private or public sector spends heaps of money on new roads, houses, and so on, then this boosts employment, demand for construction materials, and generally helps the recovery. I won’t get into the detail but plenty has been written about the merit of such projects, but with somewhat conflicting messages. On the one hand, when private sector demand is down, Keynesian economists would argue that it makes sense to use the public purse to boost aggregate demand. In the case of Japan’s lost decade, for example, Paul Krugman argues that the only problem with their infrastructure investment programme was that it wasn’t bigger, but at the very least, their spending on roads and rails kept things from getting substantially worse. On the other side, the Austrian school thinks that stimulus spending simply delays the inevitable realignment of the economy by propping up losing industries. (Reading between the lines, Michael White implies there might be some sort of benefit in selling our expertise in writing the PFI contracts.)

While I’m not a card-carrying economist, on the question of infrastructure as stimulus, my intuition would be similar to Dieter Helm’s argument: if the economy is depressed and savings can’t achieve good returns anywhere else, then you might as well invest them in long-term productive assets like infrastructure.

To my mind though, the more interesting question is whether or not these investments are likely to deliver long-term growth. Chris Kennedy’s recent book on the wealth of cities makes the point that infrastructures create patterns of consumption that last decades. Motorway networks for example have established an entire economy around vehicle manufacturing and repair, and support a suburban lifestyle with larger houses that need to built and filled with more stuff.

These sorts of effects can be seen in the following plot. It shows the UK’s GDP since 1500 and I’ve fitted three regression lines: one to the pre-Industrial Revolution period, another to the period after the UK railway boom of the 1830s and 40s, and a third to the post-war period or modern industrial age. The results are clear: each stage has a distinctly different slope, meaning that average rates of growth are in different in each period (0.07% prior to the industrial revolution, 1.1% after the railway boom, and 2.1% in the modern era). I would suggest these changes are due to the infrastructure investments made at the start of the period: railway investments at the start of the 19th century boom, and modern manufacturing methods and the use of oil in the 20th century.

Historic UK GDP and major infrastructure periods

Historic UK GDP and major infrastructure periods. Data from Angus Maddison's historic GDP statistics. Click for bigger.

This analysis isn’t entirely novel and fits in with the notion of Kondratiev waves. But it does suggest that only some of the proposed infrastructure improvements will lead to long-term economic benefits. New investments in the roads? That doesn’t change the structure of the economy and lead to new patterns of consumption; it only ensures that the current system keeps working. Investments in 4G mobile and high-speed broadband? These are more promising and could enable a range of new products and services.

Conclusion

In concluding his speech, the Prime Minister asked “what is it that people want for the future? They want reasonable things; a decent home, a clean environment, jobs for their children, the ability to get around without hassle, huge costs or endless jams.” These are modest aims and, despite his subsequent call to “be bold”, the discussion presented here suggests that the proposed infrastructure reforms will indeed have only minor consequences. We have seen that infrastructure will continue to be viewed as a public good in the UK, even if the private sector has a significant role as a co-provider of these services. The financing of infrastructure projects will continue to driven by a desire to keep borrowing costs off the public balance sheet, even if current low bond rates suggest and the poor value of past PFI contracts suggests that this may not be the best strategy. And finally, while there may be some short-term boosts in economic activity, the long-term prospects are mixed. Improvements in communications infrastructure should help support long-term growth but investments in roads and housing are largely maintenance, part of the ongoing costs of supporting our current way of life.

Further reading

  • Dieter Helm comment piece on the relationship between infrastructure, GDP and national prosperity

  • Chapters 18 and 19 of E.F. Schumacher’s Small is Beautiful contain a useful discussion on public versus private goods, in particular noting the benefits that private firms receive from the public provision of these services.

Economic models as analogies

This paper should be mandatory reading before anyone tries to decode an economic model. For engineers or physical scientists, the mathematical formalism of economics seems familiar but that’s about it. In particular the assumptions used seem woefully inadequate to act as a foundation for any meaningful representation of the real world. Rational consumer and firm behaviour, stylised economies with only one product (made with no capital) and the like may help make the math work out, but good luck finding homo economicus out in the field, carefully evaluating the marginal utility of just one more orange in the grocery store.

The authors of this paper however (economists themselves) are careful to point out that the function of economic models is slightly different. The confusion arises when we think of economic models as “rule-based knowledge”, that is representative pieces of knowledge that summarize the results of multiple individual cases. For example, if we watched the arc of thousands of balls fly through the air at different velocities and angles, we could state a general “rule” of Newton mechanics to explain this path. Economic models, on the other hand, are examples of “case-based knowledge” and should be treated like a piece of experimental data, a paper from the literature, an anecdote, or any other piece of information that helps the analyst think about a particular problem. In other words, theoretical models allow economists to play around with situations which may be intentionally unrealistic, but can nevertheless provide valuable insight to a real problem.

This seems like such a fundamental bit of epistemology that I find it hard to believe it’s not more widely known, among engineers, the general public, but also economists themselves. Indeed the wealth of quotes about economic models needing “beauty before truth” suggests that perhaps the economics profession itself has forgotten the difference between case-based and rule-based knowledge.

In any event, it’s an excellent paper with a nice summary of the standard critiques of economic modelling, the difference between rule and case-based knowledge and, ironically, an economic model explaining the argument. The key conclusion is that, whatever form of knowledge one uses, one should be clear about the limits of relevance and validity inherent in any given tool. The abstract:

People often wonder why economists analyze models whose assumptions are known to be false, while economists feel that they learn a great deal from such exercises. We suggest that part of the knowledge generated by academic economists is case-based rather than rule-based. That is, instead of offering general rules or theories that should be contrasted with data, economists often analyze models that are “theoretical cases”, which help understand economic problems by drawing analogies between the model and the problem. According to this view, economic models, empirical data, experimental results and other sources of knowledge are all on equal footing, that is, they all provide cases to which a given problem can be compared. We offer some complexity arguments that explain why case-based reasoning may sometimes be the method of choice; why economists prefer simple examples; and why a paradigm may be useful even if it does not produce theories.

The Evolution of Great World Cities

Book review: The Evolution of Great World Cities

The Evolution of Great World CitiesLooking at Yves Marchand and Romain Meffre’s recent photoessay on Detroit, one can’t help but wonder what happened. How did a city that was literally the engine of the American economy sputter and decay into a mass of peeling paint, broken windows, and faded twentieth-century glamour? And on the flip side, how can a city like Dubai, with its Burj Khalifa tower stretching nearly 1 km into the sky, rise out of the desert in such a short period of time?

These are some of the questions that Chris Kennedy’s new book, The Evolution of Great World Cities, seeks to answer. Kennedy is a professor of civil engineering at the University of Toronto with a soft spot for cities and economics. Launching the book in London last week, he noted that he originally wanted to investigate the wealth of cities in much the same way that Adam Smith had done for the wealth of nations. But along the way, the book changed into something subtly different and the result is a fascinating mix of macroeconomics, infrastructure engineering, history, and ecology.

Philadelphia's City Hall

The book has three main themes. First, it provides a useful definition for the wealth of cities, namely as the cumulative assets of its citizens. This omits the value of public buildings and infrastructure, a distinction that seems counter-intuitive at first. How can a city’s most prominent buildings, such as Philadelphia’s $6 billion dollar town hall not be included in such a total? However as Kennedy describes, the value of these facilities is reflected in the locational value of people’s homes; a home with access to first-rate transport, water, and energy supplies will have a higher value than a cabin in the woods with no such services and amenities. Using the example of 16th century Seville, the importance of citizen ownership is also demonstrated. Tonnes of Incan gold may have flowed through Seville’s gates, but most of it was destined for the hands of foreign owners, namely the bankers in Antwerp and Genoa that financed many of the trans-Atlantic expeditions.

The second theme is the connection between economic growth and the physical structure of cities. Take the automobile as an example. Its introduction in the early twentieth century led to a new mode of urban development, suburban sprawl, which although it has many disadvantages certainly leads to increased consumption. Cars need to manufactured, sold, and serviced; larger suburban homes need to be constructed with more materials and filled with consumer goods. The key issue here is not the infrastructure itself, but the modes of consumption that it necessitates. For example, one might expect that the 1990s IT revolution would have led to a demand side crisis. Just like Smith’s pin-makers, those displaced by the productivity gains of IT – bank tellers, backroom operations, and so on – would be unemployed and unable to consume. However IT also created new opportunities in PC manufacturing, software design, and innovative business models like EBay and Amazon. This new online way of life drove a new cycle of demand, rejuvenating the economy.

To me, this is the book’s most important contribution. This idea of the autonomous consumption of infrastructure, that is the societally mandatory level of minimum consumption created by these systems, is hugely important for understanding not just the economic growth that Kennedy is concerned about, but more broadly the sustainability of cities. North American urban sprawl is a perfect example. While it engenders high levels of consumption, maintaining that lifestyle depends on a throughput of resources, most importantly abundant and affordable transport fuel. Should these fuels become significantly more expensive, these cities would grind to a halt. The same level of infrastructure-mandated autonomous consumption would still be there, but it would now consume a much larger portion of a household’s income, leading to reduced savings, reduced investment in new opportunities, and eventual stagnation. In the language of sustainable development, the autonomous consumption of infrastructure represents a liability that must be serviced on an on-going basis.

The third theme is an analysis of urban economic processes as ecological systems. The relevant chapter offers several noteworthy ideas but it felt incomplete compared to the rest of the tightly-argued book. Nevertheless, an excellent description of Detroit’s decline is provided and the statistics cannot fail to astound: a population decline of 50% between 1930 and today, over 60 square miles of vacant abandoned land (44% of the city’s area), local tree species poking through factory floors that once produced millions of automobiles. Kennedy argues that, in much the same way that an ecosystem needs diversity to survive a changing environment, Detroit was too focused on cars in order to survive, both in terms of the limited diversity of its economy and the inflexibility of its infrastructure. One of the great what-ifs posed by the book is what Detroit might look like now had a 1923 proposal for a subway and integrated transit system been implemented.

Illustrated with case studies on cities as diverse as Toronto and Montreal, Philadelphia and New York, Seville, Paris, Dubai, and London, The Evolution of Great World Cities is a unique work of economic geography. Engineers often complain that economic models are too abstract to offer a meaningful understanding of the real world. Kennedy has therefore done both professions a great service by presenting a strong argument that it is the links between our built environment and economies that matter most.

Chris Kennedy has also written a blog post about the book over at the World Bank’s Sustainable Cities site.

Prosperity Without Growth

At the end of March, just before the G20, the Sustainable Development Commission released a provocatively titled report: “Prosperity Without Growth“. I didn’t actually hear about it when it first came out but only stumbled across it later via an email newsletter.

At first I thought, ‘Well, I must not have read the paper properly that day.’ But a retrospective search turns up only two Guardian articles (one news, one opinion), a cranky opinion piece in the Times, and nothing in the Telegraph, Independent, or Economist.

This is disappointing. The report asks serious questions about how our society seeks to improve the lives of its citizens and it’s been almost entirely ignored by the mainstream media. And while the blogs do take up some of the slack, the debate isn’t always as rigorous as one might hope.

Having now read some comments from around the web, and re-examined the original report, I think part of this apathy is because of the definitional baggage and misunderstanding that surrounds the concept of economic growth. Let me explain what I mean.

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BIEE white paper conference: tax or trade?

Last week the BIEE hosted an “academic critique” of the recent energy white paper. It was a well-attended event with insightful presentations from economists, engineers, and social scientists. I’d read the white paper when it came out but, as I do less policy work now, a forum like this is really useful to help understand what the big wigs think are the important issues. Perhaps not surprisingly, most were disappointed with the white paper in one way or another: it didn’t take into account recent policy changes (e.g. the EU energy and climate Action Plan), it gave insufficient attention to domestic security of supply issues and it generally failed to provide enough detail for academics (or anyone else) to independently verify the white paper’s chances of success.

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