The Picture That Quashes 50 Years of Economic Malarky

by Dirk Ehnts

Expansionary fiscal policy increases the real interest rate and crowds out private investment.

The above line is something which you might find in an ordinary economics textbook. Let me repeat it: Expansionary fiscal policy increases the real interest rate and crowds out private investment. The way it is put makes it seem like a no-brainer – unless you take a look at the data. In the graph below the Read more … break, the blue line is the federal surplus or deficit, the red line is gross private domestic investment (Wikipedia entry), and the black line is the real interest rate (federal funds rate minus the inflation rate).

Click on photo for larger picture of real crowding out.

Now if a statement is put into a textbook matter-of-factly, then I expect to find something else than I actually do find in the graph above.  Government debt was rising since the 1980s, but real interest rates fell over time and investment in the private sector increased in levels. Now you might say that with some fancy econometrics you would get the right result, but to that I would reply that you could get any result with econometrics. The statement in the title of this post is a strong one and I would have expected that a quick fact check mission to FRED2 would lead me to nod my head and mumble “yup”.

So, my reading is that the Fed controls the nominal interest rate through monetary operations. It is what they want it to be, and changes in government spending don’t drive it. Maybe there is an effect of expansionary fiscal policy on real interest rates, but it doesn’t seem to be the dominating story.

Editor’s note: Read the comment stream at Econoblog 101 for further discussion and insight.

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