Urban[ism] Legend: Positive NPV Infrastructure

As Washington debates how many hundreds-of-billions of the nearly trillion-dollar stimulus will go towards infrastructure or to other spending/tax cut schemes, pundits claim that spending billions on “shovel ready” public works projects can effectively create jobs that will lead to recovery. As readers probably know, I am skeptical that the anticipated spending could be activated so quickly. As Bruce Bartlett put it:

Despite claims by the Conference of Mayors and the transportation lobby that there is as much as $96 billion in construction “ready to go,” the fact is that it takes a long time before meaningful numbers of workers can be hired for such projects.

As a recent Congressional Budget Office study explains, “Practically speaking … public works involve long start-up lags. … Even those that are ‘on the shelf’ generally cannot be undertaken quickly enough to provide timely stimulus to the economy.”

The prospects for unconventional projects such as alternative energy sources are even worse. The CBO calls them “totally impractical for counter-cyclical policy” because they take even longer to come online…

Finally, the impact of increased public works spending on state and local governments cannot be ignored. Most federal transportation spending goes for projects initiated by them. When they think there is a chance that the federal government will increase its funding, they tend to cut back on their own spending in hopes that the feds will foot the bill. A study by economist Edward Gramlich found that the $2 billion appropriated by the Local Public Works Act of 1976 postponed $22 billion in total spending as state and local governments competed for federal funds and actually reduced GDP by $30 billion ($225 billion today).

Meanwhile, proponents of infrastructure spending claim that Congress should sift through the shelved projects to identify those projects that will be economically beneficial, or in other words, have a “positive net present value”. One particular free-market impostor is bold enough to advocate highway spending, as “new roads can largely pay for themselves through tolls and other user fees.”

For the non-financial types, Net Present Value (NPV) is the amount of wealth created, discounted (per the time value of money) to the present, of a particular endeavor. Or in other words, positive NPV projects are expected to “pay for themselves”, from an investment point of view. As a simple rule, opportunities that have a positive NPV should be pursued, and negative NPV projects should be avoided.

2008 Nobel Prize winner Paul Krugman possibly infers positive NPV when he says “public investment leaves something of value behind when the stimulus is over”, but just because something of value is left behind doesn’t mean it was a good investment or that it had positive NPV. At the same time, if not inferring positive NPV, Krugman’s inference that something of value is left behind by private investment makes me think that he actually believes NY Times readers will be easily deceived by his amateurish sleight of hand.

While we know that something of value will be created by infrastructure spending, how certain can we be that alternative spending ideas won’t create something of greater value.

Those who claim positive NPV public infrastructure projects are plentiful neglect some common features of infrastructure projects. From my first-hand experience and study, ambitious, large-scale projects are vulnerable to huge cost overruns. I don’t feel I’m going out going out on a limb when I say that very large projects that are completed on-budget or under-budget are a rarity.

Having been involved with many extremely large projects, one thing has been consistent – they have grossly cost more than originally conceived. There are long-standing jokes (not so funny for taxpayers) among consultants that when estimating big projects in Chicago (and I imagine everywhere), you have to assume the cost at the end of the day will be a factor of 2-3 times as expensive. (The factor varies depending on whether it’s airport work, highway work, or other boondoggles.)

I typically attribute the under-estimation to “optimism bias” of project proponents. Politicians promise the public benefits of the project to voters, and if lucky have the project named after themselves.  Often, by the time the over-budget project is complete, the politician’s term will have ended. If all goes as planned, the politician will have moved to a higher office by then. Often, voters forget the cost over-runs of a boondoggle project once they start using it. After all, it was only a few dollars out of each of their pockets.

Furthermore, bureaucrats are driven to expand their departments and budgets. Designers and consultants who advise on the feasibility of the project are interested in eventually having the inside track on the full commission They thus have the incentive to low ball cost estimates, and inflate benefits. Contractors initially bid low, knowing huge projects are full of changes that are typically more lucrative than the original scope.  Estimators often neglect potential risks such as unexpected soil conditions.  They may neglect these things out of expediency, incompetence, or willfully in order to further a project that has the potential to bring future fees.

Industry lobbies produce studies that exaggerate the need for certain projects. Furthermore, project feasibility studies often neglect or underestimate the time needed to condemn the land needed for the large projects, as they usually are not careful to properly anticipate resistance from landowners who do not wish to give up their land or live near the blighted construction site.

For a more in-depth look, Bent Flyvbjerg has extensively studied cost overruns of large projects and similar topics:
How Optimism Bias and Strategic Misrepresentation Undermine Implementation Concept Report No 17 Chapter 3, Bent Flyvbjerg, January 4, 2007.

Characteristics of Large Infrastructure Projects

Large infrastructure projects, and planning for such projects, generally have the following characteristics (Flyvbjerg and Cowi, 2004):

• Such projects are inherently risky due to long planning horizons and complex interfaces.
• Technology is often not standard.
• Decision making and planning is often multi-actor processes with conflicting interests.
• Often the project scope or ambition level change significantly over time.
• Statistical evidence shows that such unplanned events are often unaccounted for, leaving budget contingencies inadequate.
• As a consequence, misinformation about costs, benefits, and risks is the norm.
• The result is cost overruns and/or benefit shortfalls with a majority of projects.

Projects With Cost Overruns and Benefit Shortfalls

The list of examples of projects with cost overruns and/or benefit shortfalls is seemingly endless (Flyvbjerg, 2005a).

Boston‘s Big Dig, – 275 percent or US$11 billion over budget in constant dollars when it opened, and further overruns are accruing due to faulty construction.

Denver‘s $5 billion International Airport were close to 200 percent higher than estimated costs.

The overrun on the San Francisco-Oakland Bay Bridge retrofit was $2.5 billion, or more than 100 percent, even before construction started.

The Channel tunnel between the UK and France came in 80 percent over budget for construction and 140 percent over for financing. At the initial public offering, Eurotunnel, the private owner of the tunnel, lured investors by telling them that 10 percent “would be a reasonable allowance for the possible impact of unforeseen circumstances on construction costs.”

Policy Implications

The policy implications of the results presented above are as follows:

• Lawmakers, investors, and the public cannot trust information about costs, benefits, and risks of large infrastructure projects produced by promoters and planners of such projects.

• The current way of planning large infrastructure projects is ineffective in conventional economic terms, i.e., it leads to Pareto-inefficient investments.

• There is a strong need for reform in policy and planning for large infrastructure projects.

[hat tip: bound rationality]

Also, the wisdom of Tyler Cowen:

…quick projects are usually wasteful projects. Good new projects need to be thought out and planned. The environmental impact study alone can take years. But Obama has told the state governments they will have to “use it or lose it” when it comes to federal grants. The result will be a lot of poorly conceived projects just to capture the money.

The biggest problem with a fiscal stimulus is this: our economic problems stem from having spent too much in the first place. Now that our homes are no longer rising in value every year and America is aging, more saving is in order, not more spending. Recovery will come only when we discover which new and valuable things the economy should produce as it shifts out of real estate and finance. Simply borrowing and doling out more cash doesn’t solve that problem.

[hat tip: Positive Liberty]

and Harvard’s Linda Bilmes:

A good play to start looking for lessons is by analyzing the three biggest recent examples of heavy government spending on infrastructure: the Iraqi reconstruction effort, Hurricane Katrina reconstruction, and the Big Dig artery construction in Boston. Let me start by pointing out that all of these were plagued by a number of serious problems.

(more from Alex Tabarrok)

And if the government really wanted to, it could easily find positive NPV projects by butting its nose in the business of anti-growth cities that are unreasonably down-zoned by anti-growth policies, as noted at winterspeak:

Infrastructure Spending will be allocated the way Infrastructure Spending is always allocated — it will be based on political expediency, not whether it is a positive net present value or not. If Infrastructure was based on positive net present value, we’d have sky scrape[rs] being built in San Francisco, and 8 story apartment complexes built in Cambridge, MA, and I don’t see a whole lot of either going on.

In my opinion, there is only one true test of a positive net present value, and that is whether private capital is willing to take on a particular project. And, if private enterprise is willing to risk capital to achieve a particular endeavor, why not let them put their own money on the line instead of taxpayer funds.

The bottom line is that big projects tend to go over-budget. Even the rare big projects that are showboated as being a positive NPV investments for society, rarely are after all is said and done as their actually cost far exceed their original budgets. When private projects (positive NPV or negative) are over-budget, investors who took the risk are on the hook for the losses. When public projects are over-budget, the taxpayers are on the hook for the losses. And when it comes to big, ambitious projects, budget over-runs and sizable losses are frequent.