Why now is a good time for government to borrow and invest

By Richard Voith
Friday, October 15, 2010

Amtrak recently rolled out a $117 billion vision of true high-speed rail in the Northeast Corridor. Travel times would fall to 38 minutes from Philadelphia to New York and to only 3 1/2 hours from Washington, D.C., to Boston. These investments in the nation's densest region would spur economic growth, cut highway congestion and conserve gates and landing slots at our airports.

But can we afford it?

Total U.S. government debt exceeded 84 percent of gross domestic product (GDP) in 2009, and most observers expect that percentage to keep growing. To many people, this is unsustainable, detrimental to economic growth and burdensome to our children. Calls for lower government spending, increased taxes or both have increased, but few question whether debt levels really are too high.

Yes, the national debt as a percentage of GDP is historically high, but that may not be the most valid measure. The actual cost of servicing the national debt as a percentage of GDP is lower than it has been since 1980. That's because interest rates are at levels not seen since the mid-1950s. Low interest rates mean the benefits of debt-funded public investments in education, transportation and other infrastructure are more likely to exceed their costs.

How can this be? Surely, increased debt can't be good. But think about a family buying a home. If the family borrowed $200,000 at 7 percent interest on a 30-year fixed-rate mortgage, monthly payments would be $1,331, but the same amount at 3.5 percent results in payments of only $889. It's no different for the government or its taxpayers. If debt increases, but interest rates drop sharply, the cost to taxpayers will fall, not rise. Despite the rapid growth in total debt from 1977 to 2009, the fraction of the economy devoted to interest payments fell in the past two years.

The current low rates paid on U.S. Treasury bonds, as well as state and municipal bonds, have another important implication for government spending: Investments in long-term assets are particularly attractive.

Think about a business that's considering investing in new computer technology. In making its decision, the firm compares upfront investment costs with net revenue after paying the borrowing costs for the equipment. If future revenue minus the interest cost is large enough, the firm makes the investment. When interest costs are low, the firm is more likely to invest. The same should be true for public investment.

To evaluate public investments, benefits must be weighed against costs. For example, if we build high-speed rail in the Northeast Corridor, the key question is whether the future reduced travel time and attendant productivity increases exceed the costs, including the interest on the bonds funding the construction. A new high-speed rail system might be unattractive from a cost-benefit standpoint at 7 percent rates, but quite appealing at 3 percent. There are other reasons supporting borrowing and investing now.

First, the economy's capacity is dramatically underused. Unemployment stands at 9.6 percent, so the government can increase investment without competing with the private sector for labor and other resources.

Second, perceived high risks associated with private-sector investment resulted in relatively weak investment, despite record amounts of cash on hand among the nation's largest companies. Given the excess capacity, the skittishness of the private sector, the interest rates and the need for education and physical infrastructure, increased public investment is an attractive way to stimulate the economy and create infrastructure to ensure competitiveness.

That said, there are potentially important risks associated with increased debt-funded public investment.

One risk is future interest rate increases, but those are unlikely to rise dramatically unless the growth rate accelerates rapidly, significant inflation occurs or foreign investors stop buying Treasury securities. Fortunately, if growth accelerates, the economy will generate more tax revenue. Rapid inflation could occur, but inflation would reduce the real value of debt. And there is little evidence that foreigners are losing interest in U.S. debt, even at low yields.

Although it seems unlikely that interest rates will increase dramatically in the short term, rates are extremely difficult to predict. Still, it is prudent to minimize this interest rate risk by using long-term debt to fund infrastructure. Future rate increases won't raise the cost of servicing debt on new investments if they are financed with long-term bonds at today's bargain rates.

The largest risk is that the borrowing might not be used for investments that enhance future productivity. If that happened, expenditures might well increase current consumption at the expense of future consumption. High-speed rail investment in the Northeast is long overdue and could pay handsome dividends for us and our children.

Richard Voith is a senior vice president and principal with the Econsult/Fairmount Group in Philadelphia and an adjunct professor of real estate at the Wharton School of the University of Pennsylvania.


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