Definition of crowding out – when government spending fails to increase overall aggregate demand because higher government spending causes an equivalent fall in private sector spending and investment.
Readers Question: The U.S. govt. often runs deficits and it must sell govt. securities in order to finance those deficits. Describe the mechanics and components of the so-called “crowding out” effect associated with the use of deficit creating fiscal policies.
When the government has to borrow, it needs to borrow from the private sector. This could be private individuals, pension funds or investment trusts. It is argued that if the private sector buy government securities this will crowd out private sector investment.
Financial Crowding Out
This is the term used to describe how government borrowing can cause higher interest rates. If government needs to sell more securities, it may have to increase interest rates on its bonds to attract people to buy. For example, in the EU, bond yields rose in 2011 because markets were worried about levels of EU debt. Therefore, the increased government borrowing was at the expense of higher interest rates on government debt. These higher interest rates on bonds are likely to discourage private sector investment and spending.
However, in a recession, the government can often borrow more without interest rates rising. For example, in the UK 2009-13, bond yields fell because people wanted to save money in bonds rather than invest. Also Keynes argued that in a recession, the private sector has idle resources. Therefore, government borrowing is effectively making use of these idle resources. Financial crowding out is more likely to occur when the economy is booming already. When the economy is growing strongly, the government will have more competition from other private sector investments, therefore government bonds yields will have to rise to attract savings from other investment projects.
Resource Crowding Out
The second type of crowding out is simply the fact that if the private sector lend money to the government they have less money to invest in private sector projects.
Furthermore, it is argued that the private sector investment tends to be more efficient than the public sector investment. Therefore, the economy is worse off for government borrowing.
Crowding out doesn’t always occur.
Keynesians again argue that in a recession and liquidity trap, there is no crowding out because the government is merely spending unused resources. Keynesians argue that in a liquidity trap the LM curve is elastic. This means increased government spending doesn’t increase interest rates.
Another way of thinking about a recession is that the rise in government borrowing is merely to offset the rise in private sector saving.
This graph shows that in 2008-2012, there is a sharp rise in private sector saving. This is matched by an equivalent rise in government borrowing.