Does public investment stimulate private investment? Evidence for the euro area

•The article investigates the long run relationship between public and private investment.•Evidence is based on a stock-flow approach.•Panel econometric models are specified for the euro area.•The analysis includes I(2) and I(1) variables.•Crowding-in effects of public investment dominate in the long run.

This paper explores the long run relationship between public and private investment in the euro area. In contrast to previous studies a stock-flow approach is applied to control for the different orders of integration between the stock and flow variables. Panel econometric techniques allowing for international spillovers are employed. Private and public capital stocks are both I(2) and cointegrated. The deviations from the stock equilibrium are not (trend) stationary, but I(1). Utilizing them in a model for investment flows improves the cointegration evidence between the I(1) variables. In fact, private investment flows, GDP and the real interest rate appear to be cointegrated only if the deviations from the stock equilibrium are included. The corresponding error correction equation is well behaved. Therefore, knowledge of the stock relationship is crucial to explain the changes in private investment flows. Overall, the lack of public investment may have restricted private investment and thus GDP growth in the euro area. The results have strong implications for the future direction of fiscal austerity programs to combat the euro area debt crisis.