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.
However, in a recession, the government can often borrow more without interest rates rising. For example, at the moment, people don’t particularly want to buy shares so bonds are more attractive. 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. For example, the UK and US both saw falling bond yields over the period 2008-11 – despite increasing levels of government borrowing.
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.
However, Keynesians again argue that in a recession and liquidity trap, there is no crowding out because the government is merely spending unused resources. The rise in government borrowing is to offset the rise in private sector saving.
- How much can a government borrow?
- Deficits and the Future – Paul Krugman – why crowding out won’t occur
Crowding out is caused by the fact of the government – central bank machine borrowing in order to spend. Since no one seems to have the faintest idea how serious a problem crowding out is, there is a phenomenally simple solution to this “problem”: DONT BORROW !
In other words, since the the government – central bank machine can simply print money, why not just “print and spend” instead of “borrow and spend”. Problem solved !
Indeed, this is more or less what the UK authorities did in 2009. Trouble was that they handed too much of the money to the UK equivalent of Wall Street rather than the UK equivalent of Main Street.