In
economics
Economics () is the social science that studies the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods and services.
Economics focuses on the behaviour and intera ...
, crowding out is a phenomenon that occurs when increased
government
A government is the system or group of people governing an organized community, generally a state.
In the case of its broad associative definition, government normally consists of legislature, executive, and judiciary. Government is a ...
involvement in a sector of the
market economy
A market economy is an economic system in which the decisions regarding investment, production and distribution to the consumers are guided by the price signals created by the forces of supply and demand, where all suppliers and consumers ...
substantially affects the remainder of the market, either on the
supply
Supply may refer to:
*The amount of a resource that is available
**Supply (economics), the amount of a product which is available to customers
**Materiel, the goods and equipment for a military unit to fulfill its mission
*Supply, as in confidenc ...
or
demand
In economics, demand is the quantity of a good that consumers are willing and able to purchase at various prices during a given time. The relationship between price and quantity demand is also called the demand curve. Demand for a specific item ...
side of the market.
One type frequently discussed is when expansionary
fiscal policy
In economics and political science, fiscal policy is the use of government revenue collection (taxes or tax cuts) and expenditure to influence a country's economy. The use of government revenue expenditures to influence macroeconomic variables ...
reduces
investment spending In macroeconomics, investment "consists of the additions to the nation's capital stock of buildings, equipment, software, and inventories during a year" or, alternatively, investment spending — "spending on productive physical capital such as mach ...
by the private sector. The government spending is "crowding out" investment because it is demanding more loanable funds and thus causing increased interest rates and therefore reducing investment spending. This basic analysis has been broadened to multiple channels that might leave
total output little changed or even smaller.
Other economists use "crowding out" to refer to government providing a service or good that would otherwise be a business opportunity for private industry, and be subject only to the economic forces seen in
voluntary exchange Voluntary exchange is the act of buyers and sellers freely and willingly engaging in market transactions.
Voluntary exchange is a fundamental assumption in classical economics and neoclassical economics which forms the basis of contemporary mainstr ...
.
Behavioral economists and other social scientists also use "crowding out" to describe a downside of solutions based on private exchange: the
crowding out of intrinsic motivation and prosocial norms in response to the financial incentives of voluntary market exchange.
History
The idea of the crowding out effect, though not the term itself, has been discussed since at least the 18th century. Economic historian Jim Tomlinson wrote in 2010: "All major economic crises in twentieth century Britain have reignited simmering debates about the impact of public sector expansion on economic performance. From the '
Geddes Axe
The Geddes Axe was the drive for public economy and retrenchment in UK government expenditure recommended in the 1920s by a Committee on National Expenditure chaired by Sir Eric Geddes and with Lord Inchcape, Lord Faringdon, Sir Joseph Maclay an ...
' after the First World War, through
John Maynard Keynes
John Maynard Keynes, 1st Baron Keynes, ( ; 5 June 1883 – 21 April 1946), was an English economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originally trained in ...
' attack on the '
Treasury view
In macroeconomics, particularly in the history of economic thought, the Treasury view is the assertion that fiscal policy has ''no'' effect on the total amount of economic activity and unemployment, even during times of economic recession. This vie ...
' in the interwar years, down to the 'monetarist' assaults on the public sector of the 1970s and 1980s, it has been alleged that public sector growth in itself, but especially if funded by state borrowing, has detrimental effects on the national economy." Much of the debate in the 1970s was based on the assumption of a fixed supply of savings within a single country, but with the global capital markets of the 21st century "...international capital mobility completely undermines a simple model of crowding out".
Crowding out from government borrowing
One channel of crowding out is a reduction in private
investment
Investment is the dedication of money to purchase of an asset to attain an increase in value over a period of time. Investment requires a sacrifice of some present asset, such as time, money, or effort.
In finance, the purpose of investing i ...
that occurs because of an increase in government borrowing. If an increase in
government spending
Government spending or expenditure includes all government consumption, investment, and transfer payments. In national income accounting, the acquisition by governments of goods and services for current use, to directly satisfy the individual o ...
and/or a decrease in tax revenues leads to a deficit that is financed by increased borrowing, then the borrowing can increase
interest rates
An interest rate is the amount of interest due per period, as a proportion of the amount lent, deposited, or borrowed (called the principal sum). The total interest on an amount lent or borrowed depends on the principal sum, the interest rate, th ...
, leading to a reduction in private investment. There is some controversy in modern
macroeconomics
Macroeconomics (from the Greek prefix ''makro-'' meaning "large" + ''economics'') is a branch of economics dealing with performance, structure, behavior, and decision-making of an economy as a whole.
For example, using interest rates, taxes, and ...
on the subject, as different schools of economic thought differ on how households and financial markets would react to more government borrowing under various circumstances.
The extent to which crowding out occurs depends on the economic situation. If the economy is at capacity or full employment, then the government suddenly increasing its budget deficit (e.g., via stimulus programs) could create competition with the private sector for scarce funds available for investment, resulting in an increase in interest rates and reduced private investment or consumption. Thus the effect of the stimulus is offset by the effect of crowding out. On the other hand, if the economy is below capacity and there is a surplus of funds available for investment, an increase in the government's deficit does not result in competition with the private sector. In this scenario, the stimulus program would be much more effective. In sum, changing the government's budget deficit has a stronger impact on
GDP
Gross domestic product (GDP) is a monetary measure of the market value of all the final goods and services produced and sold (not resold) in a specific time period by countries. Due to its complex and subjective nature this measure is often ...
when the economy is below capacity. In the aftermath of the 2008
subprime mortgage crisis
The United States subprime mortgage crisis was a multinational financial crisis that occurred between 2007 and 2010 that contributed to the Financial crisis of 2007–2008, 2007–2008 global financial crisis. It was triggered by a large decline ...
, the U.S. economy remained well below capacity and there was a large surplus of funds available for investment, so increasing the budget deficit put funds to use that would otherwise have been idle.
The macroeconomic theory behind crowding out provides some useful intuition. What happens is that an increase in the demand for
loanable funds In economics, the loanable funds doctrine is a theory of the market interest rate. According to this approach, the interest rate is determined by the demand for and supply of loanable funds. The term ''loanable funds'' includes all forms of credit, ...
by the government (e.g. due to a deficit) shifts the loanable funds demand curve rightwards and upwards, increasing the
real interest rate
The real interest rate is the rate of interest an investor, saver or lender receives (or expects to receive) after allowing for inflation. It can be described more formally by the Fisher equation, which states that the real interest rate is approx ...
. A higher real interest rate increases the
opportunity cost
In microeconomic theory, the opportunity cost of a particular activity is the value or benefit given up by engaging in that activity, relative to engaging in an alternative activity. More effective it means if you chose one activity (for example ...
of borrowing money, decreasing the amount of interest-sensitive expenditures such as investment and consumption. Thus, the government has "crowded out" investment.
What factors determine how much crowding out takes place?
The extent to which interest rate adjustments dampen the output expansion induced by increased government spending is determined by:
*Income increases more than interest rates increase if the LM (Liquidity preference—Money supply) curve is flatter.
*Income increases less than interest rates increase if the IS (Investment—Saving) curve is flatter.
*Income and interest rates increase more the larger the multiplier, thus, the larger the horizontal shift in the IS curve.
In each case, the extent of crowding out is greater the more interest rate increases when government spending rises.
Economist
Laura D'Andrea Tyson
Laura D'Andrea Tyson (born June 28, 1947) is an American economist and university administrator who is currently a Distinguished Professor of the Graduate School at the Haas School of Business of the University of California, Berkeley and a senio ...
wrote in June 2012: "By itself an increase in the deficit, either in the form of an increase in government spending or a reduction in taxes, causes an increase in demand. But how this affects output, employment and growth depends on what happens to interest rates. When the economy is operating near capacity, government borrowing to finance an increase in the deficit causes interest rates to rise. Higher interest rates reduce or “crowd out” private investment, and this reduces growth. The “crowding out” argument explains why large and sustained government deficits take a toll on growth; they reduce capital formation. But this argument rests on how government deficits affect interest rates, and the relationship between government deficits and interest rates varies. When there is considerable excess capacity, an increase in government borrowing to finance an increase in the deficit does not lead to higher interest rates and does not crowd out private investment. Instead, the higher demand resulting from the increase in the deficit bolsters employment and output directly, and the resulting increase in income and economic activity in turn encourages or 'crowds in' additional private spending. The crowding-in argument is the right one for current economic conditions."
Two extreme cases
Liquidity trap
If the economy is in a hypothesized
liquidity trap
A liquidity trap is a situation, described in Keynesian economics, in which, "after the rate of interest has fallen to a certain level, liquidity preference may become virtually absolute in the sense that almost everyone prefers holding cash rathe ...
, the "Liquidity-Money" (LM) curve is horizontal, an increase in government spending has its full multiplier effect on the equilibrium income. There is no change in the interest associated with the change in government spending, thus no investment spending cut off. Therefore, there is no dampening of the effects of increased government spending on income.
If the
demand for money
In monetary economics, the demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits rather than investments. It can refer to the demand for money narrowly defined as M1 (directly spendable ...
is very sensitive to interest rates, so that the LM curve is almost horizontal, fiscal policy changes have a relatively large effect on output, while
monetary policy
Monetary policy is the policy adopted by the monetary authority of a nation to control either the interest rate payable for very short-term borrowing (borrowing by banks from each other to meet their short-term needs) or the money supply, often a ...
changes have little effect on the equilibrium output. So, if the LM curve is horizontal, monetary policy has no impact on the equilibrium of the economy and the fiscal policy has a maximal effect.
The Classical Case and crowding out
If the LM curve is vertical, then an increase in government spending has no effect on the equilibrium income and only increases the interest rates. If the demand for money is not related to the interest rate, as the vertical LM curve implies, then there is a unique level of income at which the money market is in equilibrium.
Thus, with a vertical LM curve, an increase in government spending cannot change the equilibrium income and only raises the equilibrium interest rates. But if government spending is higher and the output is unchanged, there must be an offsetting reduction in private spending. In this case, the increase in interest rates crowds out an amount of private spending equal to increase in government spending. Thus, there is full crowding out if LM is vertical.
Crowding out sources
If increased borrowing leads to higher interest rates by creating a greater
demand for money
In monetary economics, the demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits rather than investments. It can refer to the demand for money narrowly defined as M1 (directly spendable ...
and loanable funds and hence a higher "price" (''
ceteris paribus
' (also spelled '; () is a Latin phrase, meaning "other things equal"; some other English translations of the phrase are "all other things being equal", "other things held constant", "all else unchanged", and "all else being equal". A statement ...
''), the
private sector
The private sector is the part of the economy, sometimes referred to as the citizen sector, which is owned by private groups, usually as a means of establishment for profit or non profit, rather than being owned by the government.
Employment
The ...
, which is sensitive to interest rates, will likely reduce investment due to a lower rate of return. This is the investment that is crowded out. The weakening of fixed investment and other interest-sensitive expenditure counteracts to varying extents the expansionary effect of government deficits. More importantly, a fall in fixed investment by business can hurt long-term economic growth of the supply side, i.e., the growth of
potential output
In economics, potential output (also referred to as "natural gross domestic product") refers to the highest level of real gross domestic product (potential output) that can be sustained over the long term. Actual output happens in real life while p ...
.
Thus, the situation in which borrowing may lead to crowding out is that companies would like to expand productive capacity, but, because of high interest rates, cannot borrow funds with which to do so. According to American economist
Jared Bernstein
Jared Bernstein (born 1955) is an American economist. He is a senior fellow at the Center on Budget and Policy Priorities. From 2009 to 2011, Bernstein was the chief economist and economic adviser to Vice President Joe Biden in the Obama Admini ...
, writing in 2011, this scenario is "not a plausible story with excess capacity, the
Fed funds
In the United States, federal funds are overnight borrowings between banks and other entities to maintain their bank reserves at the Federal Reserve. Banks keep reserves at Federal Reserve Banks to meet their reserve requirements and to clear ...
nterestrate at zero, and companies sitting on cash that they could invest with if they saw good reasons to do so." Another American economist,
Paul Krugman
Paul Robin Krugman ( ; born February 28, 1953) is an American economist, who is Distinguished Professor of Economics at the Graduate Center of the City University of New York, and a columnist for ''The New York Times''. In 2008, Krugman was th ...
, pointed out that, after the beginning of the
recession
In economics, a recession is a business cycle contraction when there is a general decline in economic activity. Recessions generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various ...
in 2008, the federal government's borrowing increased by hundreds of billions of dollars, leading to warnings about crowding out, but instead interest rates had actually fallen. When
aggregate demand
In macroeconomics, aggregate demand (AD) or domestic final demand (DFD) is the total demand for final goods and services in an economy at a given time. It is often called effective demand, though at other times this term is distinguished. This is ...
is low, government spending tends to expand the market for private-sector products through the
fiscal multiplier
In economics, the fiscal multiplier (not to be confused with the money multiplier) is the ratio of change in national income arising from a change in government spending. More generally, the exogenous spending multiplier is the ratio of change ...
and thus stimulates – or "crowds in" – fixed investment (via the "
accelerator effect
The accelerator effect in economics is a positive effect on private fixed investment of the growth of the market economy (measured e.g. by a change in Gross Domestic Product). Rising GDP (an economic boom or prosperity) implies that businesses in g ...
"). This accelerator effect is most important when business suffers from unused industrial capacity, i.e., during a serious recession or a
depression.
Crowding out can, in principle, be avoided if the deficit is financed by simply printing money, but this carries concerns of accelerating
inflation
In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reductio ...
.
Chartalist
In macroeconomics, chartalism is a heterodox theory of money that argues that money originated historically with states' attempts to direct economic activity rather than as a spontaneous solution to the problems with barter or as a means with wh ...
and
Post-Keynesian economists
Post-Keynesian economics is a school of economic thought with its origins in ''The General Theory'' of John Maynard Keynes, with subsequent development influenced to a large degree by Michał Kalecki, Joan Robinson, Nicholas Kaldor, Sidney Wei ...
question the crowding out thesis because government bonds sales have the actual effect of lowering short-term interest rates, not raising them, since the rate for
short-term debt
The money market is a component of the economy that provides short-term funds. The money market deals in short-term loans, generally for a period of a year or less.
As short-term securities became a commodity, the money market became a compo ...
is always set by central banks. Additionally, private credit is not constrained by any "amount of funds" or "money supply" or similar concept. Rather, banks lend to any credit-worthy customer, constrained by their capitalization level and risk regulations. The resulting loan creates a deposit simultaneously, increasing the amount of
endogenous money
Endogenous money is an economy’s supply of money that is determined endogenously—that is, as a result of the interactions of other economic variables, rather than exogenously (autonomously) by an external authority such as a central bank.
T ...
at that time.
Crowding out is most plausibly effective when an economy is already at
potential output
In economics, potential output (also referred to as "natural gross domestic product") refers to the highest level of real gross domestic product (potential output) that can be sustained over the long term. Actual output happens in real life while p ...
or
full employment
Full employment is a situation in which there is no cyclical or unemployment#Cyclical unemployment, deficient-demand unemployment. Full employment does not entail the disappearance of all unemployment, as other kinds of unemployment, namely Structu ...
. Then the government's expansionary
fiscal policy
In economics and political science, fiscal policy is the use of government revenue collection (taxes or tax cuts) and expenditure to influence a country's economy. The use of government revenue expenditures to influence macroeconomic variables ...
encourages increased prices, which lead to an increased demand for
money
Money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts, such as taxes, in a particular country or socio-economic context. The primary functions which distinguish money are as ...
. This in turn leads to higher interest rates (''ceteris paribus'') and crowds out interest-sensitive spending. At potential output, businesses are in no need of markets, so that there is no room for an accelerator effect. More directly, if the economy stays at full employment
gross domestic product
Gross domestic product (GDP) is a money, monetary Measurement in economics, measure of the market value of all the final goods and services produced and sold (not resold) in a specific time period by countries. Due to its complex and subjec ...
, any increase in government purchases shifts resources away from the private sector. This phenomenon is sometimes called "real" crowding out.
Crowding out of another sort (often referred to as international crowding out) may occur due to the prevalence of floating
exchange rates
In finance, an exchange rate is the rate at which one currency will be exchanged for another currency. Currencies are most commonly national currencies, but may be sub-national as in the case of Hong Kong or supra-national as in the case of t ...
, as demonstrated by the
Mundell–Fleming model
The Mundell–Fleming model, also known as the IS-LM-BoP model (or IS-LM-BP model), is an economic model first set forth (independently) by Robert Mundell and Marcus Fleming. Reprinted in Reprinted in The model is an extension of the IS–LM mo ...
. Government borrowing leads to higher interest rates, which attract inflows of money on the
capital account
In macroeconomics and international finance, the capital account, also known as the capital and financial account records the net flow of investment transaction into an economy. It is one of the two primary components of the balance of payments, ...
from foreign financial markets into the domestic currency (i.e., into assets denominated in that currency). Under
floating exchange rate
In macroeconomics and economic policy, a floating exchange rate (also known as a fluctuating or flexible exchange rate) is a type of exchange rate regime in which a currency's value is allowed to fluctuate in response to foreign exchange mar ...
s, that leads to
appreciation of the exchange rate and thus the "crowding out" of domestic exports (which become more expensive to those using foreign currency). This counteracts the demand-promoting effects of government deficits but has no obvious negative effect on long-term economic growth.
Crowding out demand
In terms of
health economics
Health economics is a branch of economics concerned with issues related to efficiency, effectiveness, value and behavior in the production and consumption of health and healthcare. Health economics is important in determining how to improv ...
, "crowding-out" refers to the phenomenon whereby new or expanded programs meant to cover the uninsured have the effect of prompting those already enrolled in private insurance to switch to the new program. This effect was seen, for example, in expansions to Medicaid and the State Children's Health Insurance Program (SCHIP) in the late 1990s.
Therefore, high takeup rates for new or expanded programs do not merely represent the previously uninsured, but also represent those who may have been forced to shift their health insurance from the private to the public sector. As a result of these shifts, it can be projected that healthcare improvements as a result of policy change may not be as robust. In the context of the CHIP debate, this assumption was challenged by projections produced by the Congressional Budget Office, which "scored" all versions of the CHIP reauthorization and included in those scores the best assumptions available regarding the impacts of increased funding for these programs. CBO assumed that many already eligible children would become enrolled as a result of the new funding and policies in CHIP reauthorization, but that some would be eligible for private insurance. The vast majority, even in states with enrollments of those above twice the poverty line (around $40,000 for a family of four), did not have access to age-appropriate health insurance for their children. New Jersey, supposedly the model for profligacy in SCHIP with eligibility that stretched to 350% of the federal poverty level, testified that it could identify 14% crowd-out in its CHIP program.
In the context of CHIP and Medicaid, many children are eligible but not enrolled. Thus, in comparison to Medicare, which allows for near "auto-enrollment" for those over 64, children's caregivers may be required to fill out 17-page forms, produce multiple consecutive pay stubs, re-apply at more than yearly intervals and even conduct face-to-face interviews to prove the eligibility of the child. These anti-crowd-out procedures can fracture care for children, sever the connection to their medical home and lead to worse health outcomes.
Crowding out supply
Crowding out is also said to occur in charitable giving when government public policy inserts itself into roles that had traditionally been
private voluntary charity,
[
] rendering private charity unnecessary.
Crowding out has also been observed in the area of
venture capital
Venture capital (often abbreviated as VC) is a form of private equity financing that is provided by venture capital firms or funds to startups, early-stage, and emerging companies that have been deemed to have high growth potential or which ha ...
, suggesting that government involvement in
financing
Funding is the act of providing resources to finance a need, program, or project. While this is usually in the form of money, it can also take the form of effort or time from an organization or company. Generally, this word is used when a firm uses ...
commercial enterprises crowds out
private finance.
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]
References
{{Authority control
Public economics
Fiscal policy