'Crowding Out' is Coming to Get You

October 15th, 2012
in Op Ed, syndication

Written by John Lounsbury

The principle of 'crowding out' is ubiquitous in economics.  It is a standard crowded-out-kids-on-a-benchSMALLstatement in many basic economics textbooks.  A couple of definitions of crowding out are found at Wikipedia: public debt crowds out private investment and increases in government spending crowds out investment spending. The definition from Investopedia is  public spending reduces private spending.  These arguments are logically based on theories that private spending will be reduced by anticipation of higher future tax rates and higher interest rates resulting from eventual shortages of capital because the government is "hogging the money resource" so to speak.  (My words in quotes, not any distinguished economist.)

Click on cartoon for larger image of real life crowding out.

Follow up:

One writer who has the crowding out thinking is Keith Riler at American Thinker:

Two words explain all you need to know about our national economic debate. These words have the instant appeal of common sense.


The two words are crowding out. The concept is well established and the definition straightforward. Crowding out is "any reduction in private consumption or investment that occurs because of an increase in government spending."

I have engaged in a number of informal discussions about the crowding out concept in which I have questioned it and have been questioned (critically by some) in return.  My bottom line from these exchanges is that the topic needs more thorough analysis than many have given it.  This is not the start of my attempt to contribute to that analysis (in which I hope to be engaged in the coming weeks), but is simply to throw some cards on the table to explain why the subject so intrigues me.

There are a number of things I would expect to find when looking at macro economic data:

1.  Numerous examples showing significant periods of time when consumption went down after increases in government spending occurred.

2.  Numerous, if not ubiquitous, examples of private investment declining after there had been an increase in government deficits.

3.  The existence of high levels of government debt would have a depressing affect on the levels of private investment.

Here are some of the examples of data I have found that are conflicting with the above expectations.

I.   The Picture That Quashes 50 Years of Economic Malarky by Dirk Ehnts


A cursory view of the above graph leads me to the following observations:

1.  It appears that there are times when decreasing federal deficits (or rising surpluses) have coincided with increasing private investment.

2.  There are also times when increasing federal deficits have coincided with increasing private investment.

3. The long-term trend shows that private investment increases accumluate over time as do public sector deficits.

From this brief overview it appears there are a number of reasons to think that the crowding out principle is far from ubiquitous in applicability. One has to wonder if the exceptions are more prevalent than the cases where the hypothesis applies.

II.  Private Sector Balance with Recessions


Click on graph for larger image.

Changes in the private sector balance are exactly the negative of changes with the public sector balance.  Making the public sector balance more positive (reducing deficits) subtracts that amount from the private sector balance (reduces private assets).

III. Why MMT is Like an Autostereogram by Isabella Kaminska


Somehow we can't escape the balance sheet balancing.

These are some the things that I must reconcile with the crowding out hypothesis before I can accept it.  No theory can be acceptible for me unless it has all assumptions specified and agrees with all available data.  The crowding out theory may have acceptible applications but I question if they have been adequately defined.  I have not yet found a satisfactory definition in the popular economic literature and basic text books.

In reading some of the reasoning about why government spending must necessarily fail I am most amused by one of the arguments that it cannot succeed because rational people will adjust their behavior to compensate.  Because rational people will see that government deficits will require higher taxes down the road they will increase their savings rather than make expenditures and investments now because rational planning requires  saving to be able to pay the higher taxes.  I have never heard anyone argue that rational people will increase their efforts to produce more and raise their income so they can improve their standard of living now as well as in the future when taxes are higher.

The reasoning behind such logic reminds me of a well worn joke.  An economist and a friend (non-economist) are walking down the street.  They spot a $100 bill lying on the sidewalk.  As they pass, with the economist stepping directly over the money, the friend asks, "Why aren't you picking up that $100?"

The economist replies, "It must be a fake or an illusion.  People are rational and if it were real it would have already been picked up."

Related Article

The Picture That Quashes 50 Years of Economic Malarky by Dirk Ehnts

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1 comment

  1. Paul Hanly says :

    This is like inflation is coming to get you and we all know that the dire predictions of 4 years ago have not come to pass.

    Crowding out might be a risk in 5 to 10 years if the private sector starts borrowing and spending/investing again and all the private sector capacity that is presently un-utilised is either destroyed, economically redundant or fully utilised.

    Until the private sector grows, withdrawal of the public sector decreases GDP unless the foreign/external sector balance change is sufficient to offset the public sector withdrawal.

    This is firmly rooted in the mathematical identity of GDP, not ideology.

    Richard Koo explains it, Greece and Spain exemplify it.

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