Infrastructure

Infrastructure

I’ve been finding myself talking a lot to people lately about infrastructure. It normally starts with a discussion about one of the light rail projects going on at the moment (or not going on as seems to be the case with Sydney’s). The conversation often ends in a more philosophical discussion about the purpose of infrastructure investment in general.

What’s clear to me is that most people don’t ever really stop and think about the role infrastructure plays in our lives. We all expect it to be there when we need it, whether it be a hospital, school or quality road, however, we give little thought to where it comes from, how it’s funded and, most importantly, the impact it has on the economy.

Infrastructure investment has been a relatively powerful driver of economic activity in Australia (and other countries for that matter) and I believe it has the potential to become even more important in the years ahead. I also believe that the selection and delivery of projects will become increasingly problematic and controversial. Today we’re going to connect a few dots to understand why I feel there may be some bumps ahead.

Infrastructure plays a key role in setting our standard of living. Economic infrastructure such as transport systems, energy and water is pretty fundamental to modern life in general. Social infrastructure such as schools, hospitals and parks basically dictate how much we will enjoy life – for example whether we can obtain a high standard of education that provides us with valuable skills to sell to the world. Ensuring infrastructure remains at very least adequate (preferably of a high standard) is vital for ongoing prosperity on a global basis.

Consider this example… We all understand that Greece had to cut government spending a lot following its debt crisis. Major cuts to University budgets mean that less of the population has access to gaining an education. That’s bad on an individual level but think about it on a national level – effectively a generation of under-educated people. This has real ramifications within their ongoing battle to compete with fellow Euro nations like Germany under the same currency and interest rate regime.

Efficient delivery of infrastructure is important. However, when I look I look around at the moment, I see a lot of inefficiency. This Sydney light rail project is currently a debacle. I hear of plans to bulldoze perfectly good stadiums in order to rebuild them (ANZ stadium in Sydney – although fortunately the state government decided against the $2B rebuild, instead proceeding with an $810M refurbishment).

Seeing some of this, I can’t help but think that democracy is a little broken at the moment here in Australia – I really don’t think some of the projects pursued would have the support of the majority of the population.

The Pipeline:

The east coast has been in an infrastructure boom. Spending on projects has increased dramatically in recent years. Indeed, NSW plans to spend around $87 billion on infrastructure over the next 4 years and Victoria around $40B.

That’s a lot of jobs, which means a lot of income for a lot of people.

These projects have been a solid cushion to the economy following the bust of the mining boom. Yes I know, mining is still going strong but remember the massive rush to develop new mines in the post-GFC years when China pulled the stimulus lever and set resources demand and prices skyrocketing? All that investment has run its course – and its not about to re-accelerate any time soon.

Unfortunately, despite the big numbers being thrown around for future government infrastructure spending, the rate of change has peaked. Here’s a snapshot (courtesy of Macrobusiness):

Despite the big numbers planned, we’re facing an infrastructure investment cliff not unlike the mining investment cliff of a few years ago.

Undoubtedly there will be new projects announced. But it’s unlikely to be enough to keep the rate of change in investment positive which is what’s needed to actually add to GDP and employment. The reason why I believe this is because the money is going to get harder to come by.

Where does the money come from?

The money for infrastructure spending needs to come from somewhere.

Economic activity has been solid of late – and this will boost tax revenues here and now.

The NSW state government has been receiving around $700M per month in stamp duty related to housing transactions over the past 3 years. That’s on the wane as prices and transactions slip.

Let’s revisit our trusty GDP accounting identity:

GDP = C + I + G + (exports – imports)

The economy can basically be broken up into 3 components – the public sector, the private sector and the external sector.

The private sector is represented by “C” and “I”, being private sector Consumption and Investment. “G” (Government) represents the public sector whilst the external sector is basically Net Exports.

Government-funded infrastructure spending is therefore included in “G”. It’s important however to consider how the sectors are linked.

As I’ve discussed in recent months, I believe we might be on the verge of a reduction in private-sector debt – particularly households. Said another way – the private sector will seek to start to increase savings.

A reduction in private sector activity will – all things being equal – subtract from economic activity.

Throw in the projected infrastructure\ investment downturn and the reduction in private-sector incomes this will have. This has the potential to magnify the effects of any deleveraging (from record high household debt). Deleveraging begets more economic weakness and potentially more deleveraging – these are some of those “pro-cyclical drivers” we like to talk about in economics. If the private sector retreats under the above scenario we need to see one of the other sectors step up – either the government sector or external sector.

A reduction in economic activity will reduce tax revenues. The Federal government is already running a deficit.

The big question when the economic showdown comes is; to what extent is our federal government going to be willing to run a massive deficit in order to offset private-sector saving?

Our government debt is currently very manageable, so there is the potential for further infrastructure spending.

Now, we know that a nation with their own floating fiat exchange rate such as Australia cannot become insolvent with respect to debts denominated in their own currency. Our government could unleash significant debt-fuelled stimulus in the form of infrastructure spending into the face of an economic slowdown. This would be good (especially if the projects were worthwhile and not the redevelopment of a perfectly functional stadium).

However, it’s probable that our government will be hesitant to do this on any great scale – there’s this fear that increasing debt would result in Australia going bankrupt the way Greece did.

Circling back to infrastructure, our nation is expected to need a significant amount of new investment over coming decades in order to keep pace with population growth and to ensure that our standards of living are not eroded. Given that money to fund investment might become scarcer, I really hope that our leaders can get their act together and ensure precious spending is not wasted on vanity projects. There are plenty of value-adding infrastructure projects that would provide real benefit to the country, if we are willing to fund them.