Crowd out

What factors determine how much crowding out takes place?

Economist Laura D'Andrea Tyson 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 fall in the first instance since higher net spending from the government injects liquidity into the banking system, pushing down the overnight rate. A response from the Central Bank to increase interest rates may occur if they believe the increased government spending at full resource employment would be inflationary. Higher interest rates reduce private investment, and this reduces growth. The resource “crowding out” argument purports to explain why large and sustained government deficits can take a toll on growth; they reduce capital formation in the private sector. But this argument rests on how government deficits are used. Increased net spending on highly productive state investment in physical and human infrastructure will likely increase long-run growth due to an expansion in the productive potential of the population. When there is considerable excess capacity within the economy, an increase in government deficit does not crowd out private real capital formation. 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."