Crowding Out

Crowding out is the reduction in private spending, especially business investment, that can follow an increase in government borrowing or spending. The usual mechanism is that the government competes with private borrowers for a limited pool of savings, pushing up interest rates and making some private projects unprofitable. The concept is central to debates over how effective fiscal policy is and over the long-run cost of a large national debt.

Crowding out is often set against the multiplier effect: the multiplier describes how public spending can raise total output, while crowding out describes forces that offset it. Its opposite, crowding in, occurs when public spending stimulates additional private investment. How much of each happens depends on the state of the economy, the response of the central bank and the openness of the country to foreign capital.

Imagine a small town with one bank that has a fixed amount of savings to lend. If the town council suddenly borrows a large share of it to build a new stadium, there is less left for shopkeepers who want to renovate or farmers who want new equipment. The bank can also charge everyone more, because demand for loans has risen.

That is crowding out: the council's project goes ahead, but some private projects quietly do not. Whether the town ends up better off depends on whether the stadium is worth more than the shops and tractors that were never built, and on whether the bank could have found more savings to lend.

Economists describe several channels.

• The interest-rate channel. Larger deficits raise the supply of government bonds. To sell them, yields may need to rise, lifting borrowing costs across the economy and lowering private investment.
• The credit-allocation channel. Where financial markets are shallow, banks may prefer to lend to the government, which is seen as safe, rather than to firms. In Pakistan, banks hold a large share of their assets in treasury bills and other government paper, and economists there have long argued this limits private credit; in India, the statutory liquidity ratio requires banks to hold a set share of deposits in approved government securities.
• The exchange-rate channel. In an open economy with a floating currency, higher interest rates can attract foreign capital and strengthen the currency, hurting exporters; this was described in the Mundell–Fleming model.
• Real resource crowding out. When the economy is at full employment, workers and materials used by government cannot be used by private firms at the same time, whatever the interest rate.

Most economists agree that the degree of crowding out depends on circumstances.

• Slack in the economy. In a deep recession with idle resources and weak private demand, there is little to crowd out, and public spending can draw unused savings into use.
• The central bank's reaction. If the central bank keeps interest rates unchanged, for example at the zero lower bound or in a liquidity trap, the interest-rate channel is largely switched off. If it raises rates to offset a fiscal boost to inflation, crowding out can be large.
• Capital mobility. A country that can borrow from abroad at world interest rates faces less domestic crowding out, though it accumulates external debt.
• What the money buys. Public investment in roads, ports or research can raise the return on private capital and cause crowding in, while transfers or consumption spending are less likely to.

Empirical estimates vary. Studies of the United States generally find that higher expected debt is associated with modestly higher long-term interest rates, and the Congressional Budget Office assumes in its long-term projections that a share of each additional dollar of debt reduces private investment. Studies of the 2009–2015 period, when interest rates were near zero, found little evidence of crowding out. In emerging markets with shallow banking systems, links between government borrowing and weak private credit are more often reported.

The debate also has an ideological dimension. Classical and monetarist economists tend to emphasize crowding out as a reason to keep deficits small; Keynesian economists stress that it is minor when resources are idle. Some versions of the argument are pushed further: under Ricardian equivalence, households offset government borrowing by saving more, so deficit-financed tax cuts do not raise demand at all. Policies that force domestic savers to hold government debt at low rates, sometimes called financial repression, are a form of crowding out that operates through regulation rather than prices, and are linked to discussions of monetary financing in countries under fiscal strain.

• Congressional Budget Office