Is economic growth fueled by government spending also sustainable growth?

Germany’s economy is growing faster than expected this year, according to the country’s Ministry for Economic Affairs. Part of that upside surprise is being driven by government investment in areas such as defense and infrastructure. But is economic growth fueled by public spending necessarily sustainable growth? We gave APG Expert Strategist Charles Kalshoven a quick call.

Do higher government expenditures lead to sustainable economic growth, or is there more to it?
"That depends largely on what the government spends the money on. If the spending is primarily consumptive, such as higher welfare benefits or additional funding for elderly care, it can provide a temporary boost to the economy. People have more money to spend, companies receive more orders and employment may rise. But that effect often fades once the spending stops.

The story is different when it comes to investments in areas such as infrastructure, the power grid or research. In that case, you not only create a temporary demand boost, you also expand the economy’s productive capacity. Such investments can also stimulate private investment. For example, a company is more likely to set up operations in a location with good infrastructure and sufficient electricity capacity.

Politicians, of course, are often quick to label spending as an investment because it sounds more appealing. But not every government expenditure ultimately needs to be judged by its contribution to economic growth. Some forms of spending have intrinsic social value, including the consumptive expenditures I just mentioned."

Do government investments always act as a catalyst for private investment?
"They are most effective during an economic downturn, such as a recession. In those circumstances, government investment increases demand, creates jobs and generates additional economic activity. During a boom, however, the opposite can happen. When companies are already struggling to find workers or affordable financing, additional government spending can crowd out other investments.

It is important to distinguish between the demand side and the supply side of the economy. The supply side concerns the economy’s productive capacity, while the demand side is about the demand for goods and services. During a recession, demand falls below productive capacity. Consumers spend less, businesses invest less and unemployment rises. Government investment can help by bringing demand back up."

The German government is investing heavily in defense and infrastructure. It seems obvious that infrastructure can contribute to sustainable economic growth. Can the same be said for defense spending?
"Yes, although the link is less visible than it is for infrastructure. Security and stability are essential preconditions for economic activity. If business owners worry that their property is not protected, or that a conflict could disrupt their operations, they are less likely to invest.

You can think of defense as a form of insurance. In peacetime, it may appear to be little more than a cost, but its purpose is to prevent much greater economic damage. You are investing in deterrence. If that helps prevent a conflict from escalating or a country from being invaded, you are also protecting economic activity.

Historically, defense has also played an important role in innovation. Many technological breakthroughs have been made possible through public and defense-related research. The internet is a well-known example. More broadly, governments play a much larger role in innovation than is sometimes recognized. Almost every major innovation has had a public component. That applies not only to the internet, but also to much of the technology underlying AI.

Funding research at universities and colleges, building and maintaining infrastructure, and establishing standards and regulations are all conditions that help make innovation possible."

What role does education play in this?
"Education is part of the picture as well. A literate and well-educated population facilitates knowledge sharing, innovation and productivity growth. It also shows how public investment and private enterprise often reinforce one another. At the same time, education illustrates how limited the distinction between investment and consumptive government spending can be. On paper, teachers’ salaries are classified as consumptive spending. But if you pay teachers more, does that automatically result in better education? Perhaps it helps reduce staff shortages. Perhaps it attracts more people to the profession. But the relationship is not one-to-one.

Education clearly contributes to human capital and therefore to future productivity. At the micro level, there is strong evidence for that. People who spend more years in education tend to earn higher incomes and generally enjoy better labor-market outcomes. There is little debate about that. The challenge lies at the macro level. If you increase investment in education today, it may take twenty years before the impact becomes visible in economic growth. During those twenty years, countless other things happen as well. That makes it extremely difficult to determine exactly how much economic growth ultimately results from that additional investment in education."

So government investment can contribute to sustainable economic growth, but only under the right conditions?
"There are certainly examples of investments that failed to deliver the expected benefits. Think of rarely used infrastructure projects or sports stadiums built for major events that later sit largely empty. In the end, it is not the label of ‘investment’ or ‘consumptive spending’ that matters. What matters is whether government spending actually removes bottlenecks, for example by improving the power grid, upgrading infrastructure or creating a better-educated workforce.

When that happens, investments enable all of us to become more productive and allow the economy to produce more over the long term. Ultimately, that is where sustainable economic growth comes from."