Crowding out (economics)

• 1. Introduction

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  Crowding out is the name economists give to a paradox at the heart of government spending: the act of trying to help an economy can, under certain conditions, quietly undermine it. When a government runs a deficit, it must borrow money. To attract lenders, it competes with private businesses and households for the same pool of investable funds. That competition can push interest rates higher, making it costlier for private companies to borrow and invest. The net result is that some of the economic activity the government hoped to stimulate never happens at all, squeezed out by the very policy meant to encourage it.

  But this is only one version of the phenomenon. Economists also use the term to describe what happens when a government simply provides a service that a private business might otherwise have supplied, or when cash incentives drive out the goodwill and generosity that people would have offered freely. Each version raises the same uncomfortable question: does public intervention help, or does it replace something valuable with something slightly less so? The answers, it turns out, depend heavily on the specific conditions of an economy at a particular moment in time.

• 2. A Very Old Argument

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  Economic historian Jim Tomlinson wrote in 2010 that every major economic crisis in twentieth-century Britain reignited the same underlying debate. From the "Geddes Axe" spending cuts after the First World War, through John Maynard Keynes' challenges to what he called the "Treasury view" in the interwar period, to the monetarist critiques of the 1970s and 1980s, critics repeatedly alleged that public-sector growth financed by state borrowing hurt the national economy.

  The idea behind crowding out predates even that long British debate. The phenomenon, though not the term, had been discussed since at least the 18th century. For much of that history, the argument rested on a particular assumption: that the total supply of savings available within a single country was fixed. If the government borrowed a pound, that was a pound no longer available to private investors. But the rise of global capital markets fundamentally changed this picture. As Tomlinson noted, international capital mobility in the 21st century completely undermines a simple model of crowding out, because governments can now draw on savings from around the world, not just from domestic sources.

• 3. Interest Rates and Investment

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  At its most mechanical level, the crowding out of private investment works through interest rates. When the government issues bonds to finance a deficit, it is competing with private companies that are also seeking capital from investors. To attract sufficient buyers, the government may need to offer higher returns, and that pushes up interest rates more broadly. Private firms facing higher borrowing costs may shelve expansion plans, cancel capital purchases, or reduce hiring.

  Paul Krugman pointed out after the start of the 2008 recession that the U.S. federal government's borrowing increased by hundreds of billions of dollars, generating widespread warnings about crowding out. Yet interest rates actually fell rather than rose. Economist Jared Bernstein, writing in 2011, argued that the classic crowding out story was simply not plausible when the economy had excess capacity, the Federal Reserve's benchmark rate sat near zero, and companies were already sitting on cash they had not found reasons to invest. The conditions that make crowding out a real threat are specific: an economy running near its full productive capacity, where additional demand for funds does run into genuine scarcity.

• 4. When Crowding Out Is Real

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  Economist Laura D'Andrea Tyson, writing in June 2012, laid out the logic precisely. When an economy is near full capacity, government borrowing to finance a deficit pushes interest rates upward. Higher rates reduce private investment, which reduces long-run growth. The mechanism works because businesses at full employment are not looking for more markets; there is no room for the accelerator effect, where rising demand calls forth new private spending. Any shift of resources toward the government directly shifts them away from the private sector.

  This is what some economists call "real" crowding out, and it is arguably the only version of the phenomenon that matters in a genuine sense when an economy is at full employment gross domestic product. By contrast, when considerable excess capacity exists, Tyson argued that an increase in government spending does not crowd out private capital formation at all. Instead, higher demand bolsters employment and output directly, and the resulting growth in income and activity encourages additional private spending, a dynamic she described as "crowds in." Her conclusion for conditions of large excess capacity was pointed: the crowding-in argument is the right one.

• 5. IS-LM Curves and Extreme Cases

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  Macroeconomists have long used a framework built around two curves, the IS curve representing the Investment-Saving balance and the LM curve representing Liquidity preference and Money supply, to map out when crowding out is total, partial, or absent altogether. The shape and slope of these curves determines everything.

  In a hypothesized liquidity trap, where the LM curve is horizontal, a rise in government spending carries its full multiplier effect through the economy with no change in interest rates. No investment is displaced at all. At the opposite extreme, if the LM curve is vertical and demand for money is entirely unresponsive to interest rates, government spending cannot raise total output. The interest rate rises by exactly enough to crowd out private spending equal to the new government spending. In between these two extremes, the degree of crowding out depends on how sensitive money demand and investment each are to interest rate changes. The larger the fiscal multiplier, the bigger the shift in the IS curve and the larger the income effect relative to the interest rate effect.

• 6. International and Monetary Channels

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  The Mundell-Fleming model introduces another channel: international crowding out under floating exchange rates. When government borrowing pushes domestic interest rates higher, foreign capital flows in to take advantage of the better returns. That inflow drives up the value of the domestic currency. A stronger currency makes the country's exports more expensive for foreign buyers, suppressing export demand. In this way, the fiscal stimulus crowds out not private domestic investment but the foreign sales of domestic producers.

  Chartalist and Post-Keynesian economists challenge the entire framework of nominal crowding out on different grounds. They argue that government spending initially lowers short-term interest rates rather than raising them, by injecting liquidity directly into the banking system. Central banks set the floor on short-term rates by paying interest on reserve balances; the rate is not simply determined by loanable funds supply and demand. These economists also point out that private credit is not constrained by any fixed supply of savings or money. Banks lend to creditworthy customers up to the limits set by their capitalization and risk regulations, and each loan simultaneously creates a new deposit, expanding the money supply from within.

• 7. Health Policy and Charitable Giving

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  In health economics, the term crowding out describes a distinct problem: when governments expand public insurance programs, some people who were already covered by private insurance switch to the new public option. This was observed in expansions to Medicaid and the State Children's Health Insurance Program in the late 1990s. When enrollment in a new program is high, the headline takeup rate may obscure the fact that a share of participants simply moved from private to public coverage rather than gaining coverage for the first time.

  New Jersey became a reference point in debates over SCHIP, having extended eligibility to families at up to 350% of the federal poverty level. State officials testified that they could identify a 14% crowd-out rate within their CHIP program. The Congressional Budget Office, when scoring versions of CHIP reauthorization, built assumptions about such shifts into its projections. Anti-crowd-out rules designed to keep the new programs focused on the genuinely uninsured created their own problems, however: families might face 17-page application forms, requirements for multiple consecutive pay stubs, repeated re-enrollment at intervals shorter than a year, and face-to-face interviews. Those barriers can disrupt a child's continuity of care and sever the connection to what health policy calls a medical home. Beyond health care, crowding out has also been observed in charitable giving when government programs absorb roles that private voluntary organizations had traditionally filled, and in venture capital markets when public financing enters sectors that private investors might otherwise have funded.