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Issue 12/16 September 2009

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Today’s Issue Includes:

1) High Speed Rail: What are the potential costs and benefits? By Nigel Tree

Nigel TreeThe background

Late last month Network Rail proposed a new high-speed rail link between London and Scotland via Manchester. It was estimated that the cost of building the link and operating it for the next sixty years would be £41bn and that it would produce a net increase in revenues of £23.4bn over the same period. According to Network Rail the whole project would be self-financing if the “benefits” to people being able to travel on these trains is factored in.

If the project goes ahead, it will cut travel times between London and Birmingham from 1 hour 22 minutes, to 45 minutes. And eventually passengers will be able to travel from Glasgow to London in 2 hours 16 minutes.

Costs and benefits

To attempt to work out whether such a project should go ahead, it is necessary to undertake a cost-benefit analysis. Such an analysis is being undertaken at the moment by Sir David Rowlands, chairman of the government-owned company, High Speed 2, which should report later this year.

But what factors should be taken into account? In the private sector we are concerned as to whether a project is commercially viable, and to measure this we would want to know whether private benefits exceed private costs. However, a cost-benefit analysis (CBA) on this scale will want to examine the net social benefits – whether social benefits are greater than social costs.

The government will be carrying out a CBA to see whether the project is efficient in the use of resources and is therefore socially optimal. To do this it must undertake a number of measurements. It must work out all the costs and benefits involved, both private and external, and give them a monetary value. It can then find the net social benefit of the project. It also has to bring in the concept of opportunity cost to see whether there are any better alternative ways of using the resources involved. For example, the British Chambers of Commerce expressed concern over whether other transport budgets would be cut. A spokesman said: “…any future HSR network cannot be built at the expense of upgraded road junctions, commuter services and improved connections to our ports and airports.”

What problems might be associated with such a CBA?

Firstly, lack of information. Can the government accurately identify every cost and benefit involved?

Secondly, valuation. It may be possible to estimate what people would be willing to pay for faster journeys and what benefits may accrue from faster journey times. We can also factor in the cost of the investment and upkeep. But, how accurate will these figures be? Who can estimate what demand will be in 10, 20 or 60 years? Also, many projects of this size are notorious for running well over their estimated costs.

Thirdly, externalities. As these do not depend on market transactions they are very difficult to estimate. If a High Speed Rail link reduces road congestion this is a positive externality, but exactly how would we value this reduction? According to Network Rail, the line would account for 43.7 million journeys per year by 2030, which would result in 3.8 million fewer vehicle journeys and fewer carbon dioxide emissions.

Lord Adonis, the transport minister, for example, has also said that this rail link would be a more environmentally sound alternative to domestic flights. Also, what effect will this rail link have on people living near to the line? Would compulsory purchase of houses to make way for the line cover the full loss experienced by the householder? What negative externalities might result?

Also, we could expect there to be multiplier effects from the money used to pay workers and companies, but how great would these be? Leakages from the circular flow would have to be taken into account such as savings and spending on imported goods?

Finally, discounting of future costs and benefits. Immediate costs and benefits can be priced now, but what about those which occur in twenty years time? These have to be discounted by an appropriate percentage to obtain their net present value. This is a very difficult exercise and virtually impossible on a project which is being measured over sixty years.


Will this project go ahead at all? It may well take years to come to a decision. The government is already trying to reduce net borrowing by half from £175bn this year, over the next four years. What is the likelihood they would sanction such a massive project as this?

Network Rail has already spent 12 months and 20,000 hours of work getting its report to this stage. Any further cost-benefit analysis could run into millions of pounds and would be a potential source of government failure. But government failure would be even greater if the benefits are overestimated and at the same time money is diverted away from potentially superior projects.

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2) Eurozone stimulus: A myth, some facts, and impact estimates By Volker Wieland, Professor for Monetary Theory and Policy in the House of Finance at Goethe University of Frankfurt and Director of the Centre for Financial Studies.

volker-wielandEurozone governments have engaged in substantial fiscal stimulus. This column argues against further fiscal measures, claiming that forward-looking firms and households will cut their expenditure in response to governmental expansions. It warns that further fiscal efforts risk eroding financial and monetary policies that are combating the crisis.

Fact: Fiscal stimulus packages put together by Eurozone governments were much smaller than the US package (American Recovery and Reinvestment Act, ARRA).

Announcements of discretionary fiscal measures by Eurozone governments only add up to about 1% of GDP in 2009 and a little less in 2010. The $787 billion stimulus by the US government amounts to over 5% of US GDP.

Myth: It’s the fault of the German government. If only they had followed the example set by the Americans, the Eurozone economy would have enjoyed a big boost, and the recession would have been much smaller.

This view still appears to be widely held. To give just one example, as recently as July 20, the German business daily Handelsblatt reported on an interview with Robert Shiller under the front-page heading “We need more stimulus” as follows:

Handelsblatt: Nobel prize winner Paul Krugman accused the German government some months ago of "boneheadedness" in fighting the recession. How do you judge the crisis management in Germany?

Shiller: My impression is that the stimulus program of the German government was weak. Though the money from the stimulus package in America was also flowing with some delay, it has at least strengthened confidence. In this regard the US was more active.

Fact: The German government, which was heavily criticised in the fall of 2008 for not spending enough, quickly followed up with a second “Konjunkturpaket” in January 2009. The two fiscal packages, together, imply additional spending, transfers, and tax cuts of about 1.5% in 2009 and 2% in 2010. This is actually quite close to the US stimulus for those two years, since the ARRA measures are spread over five years.

The German stimulus is about 50% of the Eurozone stimulus, quite a bit more than its share in Eurozone GDP. Given that Germany is a country with much more pronounced automatic stabilisers than the US, this is a strong sign of fiscal activism. Thus, the German government should get good grades from those who trust in the boosting power of fiscal stimulus.

How much of a boost to Eurozone GDP should we expect?

Proponents of discretionary fiscal stimulus hope for a Keynesian multiplier effect. It follows from the national accounts spending identity when combined with the textbook Keynesian consumption function. The latter has current income as the main driver of consumption spending. A government-induced increase in total spending then raises income and boosts private consumption, which in turn raises total spending further.

Does the multiplier work? The recent debate in the US indicates quite some disagreement even among Keynesian economists. President Obama’s advisers Christina Romer and Jared Bernstein estimate that 1% of government spending would generate a 1.6% increase in GDP. They give much weight to the type of traditional macro models used by some forecasting firms. As a result, they believe the ARRA stimulus is good for 3% to 4% additional growth by end of 2010. A robustness analysis with New-Keynesian models conducted by Cogan, Cwik, Taylor, and Wieland (2009) indicates only about one-sixth of this effect. Our analysis suggests government spending quickly crowds out private consumption and investment, because forward-looking households and firms will consider eventual increases in future taxes, government debt, and interest rates.

New evidence on the multiplier

In a recent paper, Tobias Cwik and I assess the magnitude of Eurozone stimulus and construct a range of impact estimates (Cwik and Wieland 2009). We use a database of macroeconomic models that includes several models developed and used at important policy institutions such as the ECB, the EU Commission, and the IMF.

Our findings confirm the earlier analysis with models of the US economy. Once you allow for a significant role of forward-looking behaviour by households and firms, there is no multiplier. The expectation of future tax increases, or rising government debt and future interest rate increases leads to a reduction in private consumption and investment spending. This holds in particular for the three New Keynesian models developed by economists at the ECB, the IMF and the EU Commission (see Smets and Wouters 2003, Laxton and Pesenti 2003, and Ratto, Roeger and in’t Veld 2009). These models include extensive Keynesian features such as price and wage rigidities, but also employ up-to-date microeconomic foundations. The model of EU Commission researchers is especially interesting because it is recently estimated and one-third of its households do not care about the future and follow a traditional Keynesian consumption function.

Broadly similar results are obtained in the multi-country model of Taylor (1993), a slightly older vintage of New Keynesian economics with price and wage rigidities and forward-looking households and firms. Only the ECB’s area-wide model delivers the desired multiplier effect. However, all its firms and households look backwards. Its developers therefore caution that it is adequate for short-term forecasts but not the evaluation of major policy changes (Fagan et al. 2005).

Likely implementation lags make things worse. If anticipated, the initial effect of fiscal stimulus may even be negative. Monetary accommodation, of course, helps. For example, if the ECB puts off the usual interest rate increases for a year, the fiscal stimulus gets more play, but not enough to generate a substantial multiplier.

Spillovers to Eurozone neighbours and a conclusion

Additional spending may partly be diverted to imports. For this reason, proponents of fiscal stimulus in Europe have talked much about spillover effects and lobbied for coordinated measures. As it turns out, Eurozone stimulus remained limited because most Eurozone members did not really follow the US example.

Using Taylor’s multi-country model, we tried to estimate likely spillovers from the major stimulus package in Germany to France and Italy. This model exhibits significant direct demand effects for French and Italian exports. Nevertheless, the spillovers are negligible. Readers who remember the impact of the German unification spending boom on members of the European Monetary System in the early 1990s will not be surprised. The direct demand effects are offset by the upward pressure on the exchange rate with countries outside the Eurozone, as well as the expectation of somewhat higher future interest rates.


In light of these findings, European policy makers ought to ignore calls for further stimulus packages. Instead, they should carefully monitor the impact of decisions already taken on the burden imposed on future taxpayers. If governments exhaust their fiscal space in measures that have little aggregate effect, their continued capability to back up the financial system will be questioned. At the same time, the economy is likely to benefit more from the increases in base money engineered by the ECB than traditional Keynesians would tend to believe (see Orphanides and Wieland 2000). In addition, fiscal responsibility on behalf of Eurozone governments would help avoid a premature exit from unconventional measures by the ECB.


Cogan, John, Tobias Cwik, John B. Taylor and Volker Wieland (2009), “New Keynesian versus Old Keynesian Government Spending Multipliers”, CEPR Discussion Paper 7236, March.
Cwik, Tobias and Volker Wieland, (2009), “Keynesian government spending multipliers and spillovers in the Eurozone, CEPR Discussion Paper 7389, August.
Fagan, Gabriel, Jerome Henry and Ricardo Mestre, An area-wide model for the Eurozone, Economic Modelling, 2005.
Laxton, Douglas and Paulo Pesenti, (2003), Monetary rules for small, open emerging economies. Journal of Monetary Economics, 50, 1109-1146.
Orphanides, Athanasios and Volker Wieland, (2000), Efficient Monetary Policy Design Near Price Stability, Journal of the Japanese and International Economies, 14, 327-365.
Ratto, Marco, Werner Roeger, and Jan in’t Veld (2009), Quest III, An estimated open-economy DSGE model of the Eurozone with fiscal and monetary policy, Economic Modelling 26(1), 222-233.
Romer, Christina and Jared Bernstein (2009), “The Job Impact of the American Recovery and Reinvestment Plan”, January 8, 2009.
Smets, Frank and Raf Wouters (2003), “An estimated dynamic general equilibrium model of the Eurozone”, Journal of the European Economic Assocation, 1, 11-23-1175.
Taylor, John B. (1993), Macroeconomic Policy in a World Economy: From Econometric Design to Practical Operation, WW Norton, New York.



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