Crowding out

When the government borrows and spends more, does it add to the economy, or merely displace private activity that would have happened anyway? Crowding out is the fear of the latter.

Crowding out is the reduction in private spending, especially investment, that can result from an increase in government borrowing and spending. The concern is that public activity, rather than adding to total demand, simply displaces private activity, leaving the economy little better off.

The mechanism

The classic channel runs through interest rates. When a government borrows heavily to finance spending, it competes for a limited pool of savings, pushing up interest rates. Higher rates make borrowing dearer for firms and households, so private investment and spending fall. To the extent this happens, the stimulus from public spending is offset by the private spending it discourages, and the fiscal multiplier shrinks toward one or below.

When it bites, and when it does not

How much crowding out occurs depends crucially on the state of the economy. When the economy is near full capacity, with savings fully employed, extra government borrowing is more likely to bid up rates and crowd out private activity. When the economy is depressed, with idle resources, slack savings, and interest rates pinned at their floor, there is little to crowd out, and public spending can raise output substantially. This is why the same fiscal action can be effective in a slump and largely self-defeating in a boom.

Crowding in

There is a hopeful counterpart. Government spending can sometimes crowd in private activity rather than crowd it out, when public investment, in infrastructure, say, raises the returns to private investment, or when stimulus in a slump revives confidence and demand that encourages firms to invest. Whether public spending crowds out or crowds in is therefore not settled in the abstract but depends on conditions and on what the money is spent on.

Crowding out is the central objection to fiscal activism, and like the multiplier it has no single answer. Its force depends on whether the economy is straining against its limits or languishing below them, which is why the debate over government spending so often turns on a disagreement about the state of the economy itself.