The fiscal crises now besetting several OECD countries risk replaying the long agony of over-indebtedness in Africa. In Africa the process was directly overseen by the IMF. Its model of debt sustainability implicitly assumed that public investment was entirely unproductive: this was the implication of the absence from the model of any link between public investment and subsequent growth. Given this model, the only reliable way to attain debt sustainability was to reduce public expenditure: higher tax revenues might discourage private investment, but lower public spending could have no impact on growth. There are already indications of this strategy in the OECD: debt sustainability will be restored by cutting public expenditures, and the least politically sensitive component of expenditure is investment.
To its credit, the IMF is now revisiting its earlier assumptions. In an important new working paper, Public Capital and Growth (Arslanalp et al., IMF WP 10/175), its Fiscal Affairs Department analyzes the relationship between public investment and growth, both in the OECD and developing countries. The paper finds that public capital is productive, but subject to diminishing returns. Beyond a certain level of the public capital stock further investment is unproductive. In the process of the analysis it also develops new estimates of trends in the public capital stock, although even these are badly out of date, ending in 2001. The trends are, however, striking. In a few countries, such as France, the public capital stock has stayed fairly constant at around 50 percent of GDP. But in much of the OECD and in many developing countries the public capital stock has been declining relative to GDP from its peak in the mid-1980s. Many of these countries are now within the range at which, on the IMF analysis, public investment is productive.
As the paper notes, this has important implications for debt sustainability. The effect of reductions in public expenditure on debt sustainability now become contingent on what types of expenditure are being reduced: a reduction in liabilities may worsen the balance sheet if it is achieved by a reduction in productive assets. Superficially, this may suggest that the key distinction in public accounts is between recurrent and capital expenditures. However, this alone is insufficient: the critical issue is the consequence of public investment for economic growth, and in particular for that part of economic growth that generates future taxable revenues. At a minimum, public investment needs to be disaggregated into social and economic projects. Investments in the social sectors raise well-being, but may not raise taxable income. Indeed, on the contrary, they may indirectly increase claims on public expenditure, most evidently through the recurrent costs necessary to operate them. But even this disaggregation is insufficient. A serious analysis of debt sustainability must rest on unbiased estimates of the likely economic returns on public investment projects. This is difficult both technically and politically. Technically, the best that economics can offer is cost-benefit analysis, but this tends to be biased against large projects and this has cumulative consequences. For example, Britain, which has relied on such an approach, has manifestly inferior transport infrastructure to France, with its willingness to undertake transformational infrastructure projects that ex ante cannot readily be assessed. Politically, cost-benefit analysis is difficult because it requires politicians to defer to technocratic choices. Currently there are moves in some OECD countries towards independent bureaus for budgetary assessment, and this seems desirable. Potentially, it could defend the public capital stock against attempts to reduce public liabilities by cutting productive public investment.
The new IMF analysis also has important implications for developing countries. In those countries with sub-optimal public capital stocks, it licenses the government to finance increased public investment with increased borrowing, including borrowing on commercial terms. This would reverse the long-standing IMF position that developing countries with IMF Programmes should not borrow commercially. The new analysis is timely because the world is awash with liquidity. The rate of interest is at a historically low level, and the OECD countries are no longer seen automatically as safe havens. Further, as a result of the Jubilee campaign of debt forgiveness, many developing countries have very low levels of debt. Hence, there has seldom been a more propitious time for those developing countries that lack public capital to raise the finance to acquire it. This brings to the fore an issue which has not been a priority. The ability to finance public investment is not synonymous with the ability to undertake it efficiently. The efficient management of investment will be the key economic agenda of the coming decade.