One might also rationalise that the odds of this kind of displacement are higher when the economy is operating close to its full potential (that is, when unemployment is low, as it currently is).
So capital spending is not such a sure-fire bet as the chancellor might hope.
R&D spending effect
But there may be other areas where returns to government spending are definitely high, such as investing specifically in research and development (R&D).
Here, the economic literature generally agrees that government spending does not crowd out private spending. On the contrary, most studies now find evidence of crowding in (that is, that public spending encourages businesses to increase their own funding).
This is particularly true of public-private R&D partnerships, where government involvement can help reduce the risks for firms.
Indeed, in this instance we can observe a clearly positive relationship between government and private-sector funding for R&D. Fathom research suggests that on average, £1 of public funding could raise private funding of R&D by as much as £8.
In economic parlance, higher public funding is associated with higher private funding in that ratio, though the causal link is more speculative. Those are the kinds of multipliers the UK government should be aiming for.
Next, the question of where to spend it. The 19th century economist David Ricardo argued that a country should focus on whatever it is comparatively good at – the theory of comparative advantage.
The chart below shows Fathom’s measures of revealed comparative advantages (RCAs), which indicate that the UK’s strongest suits are services (which are typically less reliant on R&D) rather than manufacturing. But note that this definition of services includes ‘charges for intellectual property’ (that is, the licensing of ideas generated in the UK).
Of course, the UK also excels at some forms of hi-tech manufacturing, and at aerospace manufacturing in particular. Other areas the UK is traditionally good at arguably include pharmaceuticals, telecommunications equipment, and other vehicle manufacturing.
Both the prime minister and chancellor have recently signalled their hope that higher investment will raise economic growth in the long run. Incentivising private sector investment could achieve this, but trying to achieve this through public infrastructure spending might feel more like pushing on a string.
Instead, if they are seeking to bolster the UK’s long-run economic potential, they might want to focus more on R&D. Of course, ideas are less tangible than buildings and equipment, but they are what the UK is good at.
The difficulty is that the returns to R&D, though large, take a long time to come through – longer than one parliament, certainly, and maybe longer than two. That is one reason why most governments have made other uses of admittedly finite resources.
