Renowned Keynesian polymath, Woody Brock, in a presentation given at the ADC Forum in 2012, advocated for government investment in profitable private sector infrastructure projects in order to generate income with which to combat rising deficits. Basing his arguments on Arrow and Kurz’s Public Investment, the Rate of Return, and Optimal Fiscal Policy (1970), he argued the following:
We need a new investment bank with investors from around the world, with analysts paid two to three million a year to keep them non-corrupt, who do nothing but evaluate different [infrastructure projects].… These objective people using the Arrow-Kurz calculus will compute that [the rate of return on project A] is -4[ percent]. It will be posted worldwide. [Project B] has a rate of return of 16%. [It] will get the money, [Project A] doesn’t. It’s crystal clear.
In addition to generating profits for the government and balancing the budget, he claimed, this would also have additional benefits, such as job creation.
Let us examine these points, one by one. First, profitable projects (i.e., those yielding a positive return) will find voluntary funding on the free market as investors search for the most profitable venues in which to deploy their saved resources. Consequently, government investment in these projects will not create new jobs beyond those that would have been created anyway.
Strictly speaking, profitable projects will not be funded, ceteris paribus, if their return on investment (ROI) is less than the going interest rate, which is called the opportunity cost. Without loss of generality, a bank can only offer savers an interest rate of 2 percent on their savings only because it is able to invest those savings in projects that yield a return greater than 2 percent. If no such projects exist and the bank only has access to projects yielding a 1 percent return, then it must offer its savers less than 1 percent in order to avoid losses. If the government, through borrowing (Dr. Brock assumes that taxes will not be used for these purposes), redirects some of the savings that would have gone to projects yielding 2 percent into projects that yield only 1 percent, then that constitutes a loss for consumers because the higher profitability of the one project is the consequence of the fact that they prefer it to the alternative.
Let us assume that the government identifies those projects with the highest ROIs and chooses to invest in them. How can the government get the loans necessary for these investments if private investors are already bidding on them? Because the government is seen as a zero-risk borrower according to a well-known formula, the utility (U) of an investment depends on the investor’s risk aversion:
Where is E(r) the expected rate of return, A the investor’s risk aversion, and sigma squared the volatility of the investment.
A zero-risk borrower has zero volatility (i.e., the government is sure to repay its debts, and so, ceteris paribus, savers will be more inclined to loan to the government than to other actors). As a consequence of this, the government can also acquire a loan of a given height at a lower interest rate than private borrowers. Furthermore, because the government can borrow at lower interest rates, it can also outcompete private investors by offering those running the investment project a lower interest rate, allowing the latter to save on costs. So far, Dr. Brock’s plan adds up: The government acquires loans at a lower interest rate than its competitors and invests them at a lower interest rate in what consumers wanted anyway.
However, by outcompeting private investors, the government crowds out private funding for those undertakings. Individuals who would have invested in them now either choose not to invest at all, becoming consumers, or choose to invest in other, less profitable projects, thereby crowding out others, which eventually results in an increase (decrease) in the number of consumers (savers). The increase in consumers means a higher demand for consumer goods, which relatively shortens the structure of production. All things being equal, this reduces the profitability of existing projects, including the government’s, relative to new, less-roundabout projects that quickly yield more consumer goods.
Second, Dr. Brock assumes that teams of excellent analysts will be able to identify the most profitable projects for investment using the methodology developed by Drs. Arrow and Kurz. However, even assuming that the government could reliably identify excellent analysts, such individuals readily find employment in the private sector, where their salaries correspond to their diminished marginal value product (DMVP). To hire them, the government must bid them away from the private sector by offering them higher salaries (i.e., overpaying them). Thus, this part of the plan must be value-destructive. Paying these higher-than-DMVP salaries would come at the expense of the profitability of the investment, further reducing it from its already reduced state due to the shift in consumer demand.
Third, even if the government could profitably put together teams of experts and invest in the most profitable projects without shifting consumer demand away from the products of those undertakings, Dr. Brock’s unfamiliarity with Austrian Business Cycle Theory leads him to believe that those projects which appear most profitable continue to remain so. In fact, malinvestment during booms induced by credit expansion affects productive undertakings in different ways, and no one can reliably say which specific projects will be liquidated in the corrective bust that reestablishes consumer sovereignty. However, as Hayek showed in Prices and Production (1931), higher-order projects—which, of course, include infrastructure—are more likely to suffer liquidation.
Without sound fiscal policy (i.e., abstaining from an expansion of the money supply), these booms and busts will recur and it is probable that government-funded undertakings which once seemed profitable will lead to losses, forcing the government to repay the loans from taxes. Since this is precisely what Dr. Brock wanted to avoid—his goal was to use the profits from such investments to provide additional funds for the government which were not derived from taxation—we must conclude that the feasibility of his plan is not as “crystal clear” as he claims.
In the preceding considerations, we left out several important issues, such as government’s notoriously poor track record in choosing winners and losers, the perverse incentives that, in practice, always go hand-in-hand with the granting of government contracts, and the role that political goals would play in choosing between investments on the margin. By doing so, we have shown that even in the best case, Dr. Brock’s plan fails to take into account the crowding-out effect and the consequent relative shifting of consumer demand away from government-funded infrastructure projects, lowering their profitability below analysts’ expectations. That one key element in his plan—the hiring of experts—can only be done at a loss in the short run and that the high vulnerability of large-scale infrastructure projects in business cycle fluctuations means that—without an emphasis on fiscal policy—the numbers will not add up in the long run. In short, investment is best left to the private sector.
