Thursday, 1 April 2010

GDP Data Proves That Investment Works

by Michael Burke

SEB has recently argued that the Budget shows that the fiscal stimulus of 2009 worked. Stimulus measures of £50bn led to an increase in taxation revenues of £9.5bn in the first year alone, to be followed by reductions in the public deficit of £53bn in the first 5 years, and more in future years. Government investment lifts economic activity and is self-financing.

This is confirmed in the latest revision to GDP data in the final quarter of 2009. The growth rate was revised upwards to 0.4 per cent, but still leaves the economy 5.8 per cent below its peak in the first quarter of 2008. However, without the increase in government spending over that period the economy all other sectors of the economy would have contracted by 7.5 per cent, with all the consequent job losses and business failures, if the fiscal stimulus had not taken place.

It should be stressed that this is not an evaluation of the effects of stimulus, but simple arithmetic. Government spending is a component of GDP and forms part of gross fixed capital formation. At the very least, if you cut government spending you cut GDP by the same amount.
But there is also an evaluation to be made of the effect of government on the rest of the economy. This can be done using the official Input-Output tables, for some key components of government spending as shown below.

Table 1. Multipliers Arising From Government Health, Education and Social Work Spending

Source: ONS

These show the effects on other areas of the economy when, say, government investment in education leads to increased private sector output of books or computers. This ‘multiplier’ is 1.854. In this way the increase in government activity was equivalent to 1.7 per cent of GDP, but led to an overall boost inactivity of 3.15 per cent. This means the recession would actually have been more than half as severe again without government action.

This is also the source of the ‘surprise’ increase in tax revenues between the December’s Pre-Budget Report and the latest Budget. Next year the tax revenues are officially expected to be £8.6bn higher after this year’s gain of £9.5bn. These are tremendous returns on investment, on average over 18 per cent in the first two years.

The private sector is unwilling to invest currently and remains on an investment strike. Investment fell again by 2.7 per cent at the end of 2009 even as other areas of activity rebounded, led by government spending. In total private investment has fallen by 26.3 percent or £54bn. This represents 70% of the entire fall in GDP.

By contrast, government investment has softened the impact of the recession. It is also boosting government finances. The private sector isn’t working; government investment can.

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