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Crowding out refers to a process where an increase in government spending leads to a fall in private sector spending.
This occurs as a result of the increase in interest rates associated with the growth of the public sector.
Crowding out has been considered by many economists from a variety of different economic traditions, and is the subject of much debate.
The view that crowding out exists and presents a significant economic problem is central to the 'free market' economists - especially those in the 1970s who took the view that excessive growth in the public sector will inevitably result in the inefficient use of resources.
The 1970s was the period when 'monetarism' was on the rise and economists were increasingly questioning the fundamental assumptions of Keynesian economics - primarily regarding the role of the state, and the use of fiscal policy to achieve macroeconomic objectives, including job creation and economic growth.
One example of this approach can be seen in the work of British economics Bacon and Eltis (1976)1, who considered the de-industrialisation of the UK economy during the 1960s and 1970s. This, they argued, was the result of the excessive growth of the public sector.
There are two main types of crowding out.
At the heart of the transmission process between increased government spending and falling private sector investment is the role of interest rates.
If the government increases its discretionary spending and needs to fund some or all of this from the financial sector - say through selling bonds - the demand for money will increase, which, ceteris paribus, raises interest rates. At higher interest rates both consumer spending and investment spending are likely to fall. The aggregate effect on the economy is that financial resources are diverted from private firms to be used by the public sector.
Here we can see the linkage between an increase in government spending (G) and a fall in GDP (Y). Initially, via a multiplier effect, national income increases, but as a result of the government selling securities in the financial markets, the demand for scarce loanable funds increases.
This drives up interest rates, which causes a contraction in the demand by the private sector for investment goods (capital) as well as reducing the demand for consumer goods. This, in turn, leads to a fall in GDP.
Crowding out can be illustrated graphically. Here, as the government increases its borrowing the demand for loans increases from DL to DL1. This increases interest rates, from 3% to 4% in our example, which results in a contraction in demand for investment from 'I' to 'I1' - from £100bn to £60bn in our example.
As well as financial crowding out, it is also argued that as government spending increases a similar process occurs in other parts of the economy. For example, a relative increase in the public sector may push up wages in order to attract workers from the private sector.
The increased demand for labour reduces unemployment and 'tightens' the labour market, leading to possible shortages of labour available for the private sector use as well causing upward pressure on wage levels across the economy.
Those who argue that crowding out exists assert that it occurs because of a fundamental economic fact - that financial and real resources are ultimately scarce, and if one sector of the economy increases its use of these resources, fewer are available for use in other sectors. In this case, the more the (inefficient) public sector uses scarce resources, the less resources are available for the more efficient and productive private sector.
However, some economists argue the effect is small, or even non-existent. One view - referred to as the 'Ricardian equivalence' argument, after English economist David Ricardo - states that financing government spending either through borrowing or through raising taxes are 'equivalent'. In other words, it does not matter how government spending is financed as it will result in the same outcome.
This is taken further by Harvard economist Robert Barro. Barro argues that because an increase in government spending will lead individuals and organisations to expect interest rates to rise in the future, they will save more in order to pay higher interest rates. Also, they will save more to pay higher tax rates if they expect them to rise in order for the government to balance its budget. The increase in savings creates more 'loanable funds' which enter the financial markets, creating downward pressure on interest rates. In this case, private sector investment will not be adversely affected.
Of course, even if the crowding out effect exists, it may be a weak effect. This depends on the various elasticities that exist in the relevant markets. For example, if the supply of loanable funds is elastic and the demand for capital is inelastic, the impact of higher interest will be relatively small.
The crowding out effect post-financial crisis may be much smaller than it was, given that interest rates have been historically low, and very stable.
1 Bacon,R, and Eltis,W 1976: Britain's Economic Problem - too few producers, McMillan
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