What is the Crowding-Out Effect

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Definition:

The crowding-out effect is the theory that increased government spending reduces spending by the private sector.

🤔 Understanding the crowding out effect

The crowding-out effect is an economic theory that argues that rising public sector spending drives down private sector spending. The government can boost spending by doing two things: raising taxes or borrowing. Higher taxes mean consumers and companies have less left over to spend. Most government borrowing involves selling bonds. If individuals and institutional investors buy those bonds, they may have less capital left to spend on private sector investment. The government might also raise interest rates to make bonds more attractive, leading to higher interest rates generally, which discourages private borrowing and spending. Critics argue that the crowding-out theory is incorrect and that the opposite occurs in certain conditions — More government spending leads to more private spending, bolstering the economy.

Example

Let’s say a government wants to boost spending by borrowing. It increases interest rates on the bonds it sells to make them more attractive. Assume a consumer goods company had been planning to invest $5M in a new product line, expecting interest rates on loans to stay at 3 percent. If the government’s actions end up raising interest rates across the economy, the company now has to pay 4 percent interest on its loans, reducing its net return on the investment. In the end, the company may decide not to spend the money at all. Government borrowing has “crowded out” borrowing and spending by the private sector.

Takeaway

The crowding-out effect is like when a busload of tourists visits a park…

Suppose you decide to enjoy a beautiful weekend day in a nearby park. There’s plenty of space on the grass, and you find a nice spot to lay out a blanket for a picnic. Suddenly, a bus full of tourists shows up, and the park is full to bursting. There’s no room for anyone to enjoy the space, so you pack up and leave. According to the crowding-out effect, the government is like the bus — When it shows up in a segment of the market and starts spending, the people already there can’t spend as much.

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What is the crowding-out effect?

The crowding-out effect is a theory that argues increased government spending reduces private spending in the economy.

To spend more, governments have to either hike taxes or borrow, typically by selling bonds. If the government raises taxes, individuals may pay higher income or sales taxes or companies may pay higher corporate taxes. As a result, consumers and businesses have less cash left over to spend.

If the government borrows instead, it usually issues bonds — debt securities that it repays in full by a maturity date, typically with interest along the way. The crowding-out theory holds that, if investors buy government bonds, they have less capital left to spend on private sector projects and investments. Also, the government might raise interest rates on bonds to make them more attractive to investors. That increase could result in higher interest rates in other parts of the economy, such as loans. When the cost of borrowing goes up, demand declines, resulting in less borrowing and spending by consumers and companies.

The crowding-out effect, if it exists, matters because it means attempts to boost the economy through government spending could backfire. Economic theories dating back to British economist John Maynard Keynes argue for government spending to boost aggregate demand (demand for all goods and services) in an economic downturn. If any jumps in government outlays are offset by declines in private spending, that could make those efforts futile.

However, crowding-out does not always occur and remains a heavily debated theory. Some economists say it has a major impact on the economy, while others consider the effect small or non-existent.

How does the crowding-out effect work?

The crowding-out effect works based on the law of supply and demand. This economic principle states that prices go down when supply is high or demand is low, and vice versa. In this case, government spending affects the supply and demand for money.

Let’s say the economy is entering a recession, and the government decides to enact an expansionary fiscal policy. To finance extra spending, it borrows money. This increases demand for financial capital. If private savings and foreign investment stay the same, there is less overall capital available for private investment.

Part of this has to do with interest rates. As the demand for capital grows, the price of capital (interest rates) also rises. Higher interest rates, in turn, make borrowing less appealing. So companies that might have taken out a loan to finance a new factory may choose not to build it. Or an individual who was about to take out a home equity loan for a home remodel may choose to forgo it.

The government must also eventually pay back the funds it borrows. Unless spending falls in the future, the government must fund repayment through higher taxes. In anticipation of higher taxes, companies and individuals may also reduce their spending today to save more. Another reason to save is that higher interest rates mean saving offers better returns. In the end, government spending has “crowded out” private spending.

What are the types of crowding-out effects?

Some theorists have argued that crowding-out effects go beyond financial markets. Here are some examples of crowding-out effects:

Economic

The economic crowding-out effect refers to increased government borrowing and spending causing a reduction in private spending. Because government borrowing increases the cost of private loans and uses up capital that may have been deployed elsewhere, businesses and individuals don’t borrow or spend as much money.

Social welfare

The social welfare crowding-out effect refers to the idea that government spending on social programs reduces charitable giving and activity among businesses and individuals. People may feel that paying taxes to a government that provides welfare programs negates the purpose of direct giving or volunteering. Or they may feel like they’ve already given money for a good cause or that giving to charity is less impactful.

The evidence on whether the social welfare crowding-out effect exists is mixed. Some studies find a small effect, but others find no impact or even that the opposite is true.

Infrastructure

Infrastructure crowding-out occurs when a government borrows or spends money to build infrastructure, such as a road or a bridge. The theory is that federal government spending on these projects reduces investment from local governments or private organizations.

The infrastructure itself may also crowd out certain types of business. For example, government investment to build a port could cause companies serving the shipping industry to displace neighborhoods.

Healthcare

In the healthcare sector, crowding-out refers to the theory that government spending (such as expansion of public insurance) takes the place of private health insurance companies. As the government increases its spending on health, individuals see less of a need for private insurance.

The theory holds that public healthcare spending can also lead businesses to eliminate insurance they offer to employees as fewer workers use the benefit, making it more costly. In some cases, this can lead to an overall reduction in the number of insured people, despite increased government spending on health.

How does crowding-out relate to expansionary fiscal policy?

Expansionary fiscal policy is when the government either hikes spending or cuts taxes in order to put more money in the pockets of consumers and businesses. The idea is that they’ll have more money to spend, boosting the economy and reducing unemployment. The purpose of expansionary fiscal policy is to improve the health of the economy and prevent or end a recession. The idea of using government spending to boost total demand in a downturn is based on the ideas of British economist John Maynard Keynes.

If the crowding-out effect is real, that would undermine expansionary fiscal policy. The theory argues that government spending reduces private spending in the economy. That would mean that increased government spending would do nothing to boost, or could even reduce, economic growth in the long term.

Keynes admitted that crowding out could occur if the economy was near full capacity (meaning full employment). Conservative economist Milton Friedman believed that long-term government spending financed through borrowing would cause crowding out and generally argued against expansionary fiscal policy. Most economists agree that deficit-funded spending can be an effective solution for short-term economic slowdown. The major point of debate surrounds the long-term effects of borrowing.

What is crowding-in?

The crowding-in effect is a theory that argues the opposite of the crowding-out effect. According to this concept, increased government borrowing and spending increases private spending rather than reducing it.

The argument for crowding-in is that the economy does not always operate at full capacity. If the government borrows money and spends it in the marketplace, that places more money in the hands of corporations and individuals, who go on to spend it. So if the government did not borrow and spend that money, the private spending would never occur.

Proponents of this theory also argue that government borrowing and spending on specific projects, such as infrastructure, can make private investments more effective. For example, if the government spends money on improving the national highway system, making it faster and less expensive to ship goods by truck, businesses may invest more money in truck fleets. Without government investment, buying vehicles wouldn’t provide the returns necessary to justify the expense. So in this scenario, government spending increased private spending.

The crowding-in effect is part of the argument in favor of government borrowing to spend in order to stimulate a weak economy. If government borrowing and expenditure leads to more private spending, it can kickstart an economy out of recession.

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