Crowding Out Effect

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DEFINITION of 'Crowding Out Effect'

The crowding out effect is an economic theory stipulating that rises in public sector spending drive down or even eliminate private sector spending. Though the “crowding out effect” is a general term, it is often used in reference to the stifling of private spending in areas where government purchasing is high.

The crowding out effect is also often referred to simply as “crowding out.”

BREAKING DOWN 'Crowding Out Effect'

Because “crowding out” is a general term, most cases of crowding out share some important similarities, but there are a few distinct ways in which crowding out can happen.

One of the most common forms of crowding out takes place when a large government, like that of the United States, increases its borrowing. Because large governments have the power to borrow large sums of money, doing so can actually have a substantial impact on the real interest rate, raising it by a significant degree. This has the effect of absorbing the economy’s lending capacity and of discouraging businesses from engaging in capital projects. Because firms often fund such projects in part or entirely through financing, they are now discouraged from doing so because the opportunity cost of borrowing money has risen, making traditionally profitable projects funded through loans cost-prohibitive.

For example, suppose a firm has been planning a capital project that they project will cost $5 million and yield $6 million in returns, assuming that interest on their loans remains at its current rate of 3%. With this plan, the firm anticipates earning $1 million in net income. However, due to the shaky state of the economy the government announces a stimulus package that will help businesses in need but will also raise the interest rate on new loans the firm takes out to 4%. Because the interest rate the firm had factored into its accounting has increased by 33.3%, its profit model shifts wildly and the firm estimates that it will now need to spend $5.75 million on the project in order to make the same $6 million in returns. The firm’s projected earnings have now decreased from $1 million to $250,000, a 75% drop, and the company decides that given the time and resources they would need to put into the project, they would be better off pursuing other options.

Crowding Out in Healthy vs. Depressed Economies

This reduction in capital projects can partially offset benefits brought about through the government borrowing, such as those of economic stimulus, though this is only likely when the economy is operating at capacity. In this respect, government stimulus is theoretically more effective when the economy is below capacity. If this is the case, however, an economic downswing may even occur, reducing revenues the government collects through taxes and spurring the government’s need to borrow even more money, which can theoretically lead to a vicious cycle of borrowing and crowding out.

Crowding Out and Social Welfare

Crowding out may also take place because of social welfare, unlikely as this may seem, though indirectly. This happens when governments raise taxes in order to fund the introduction of new welfare programs or the expansion of existing ones. With higher taxes, individuals and businesses are left with less discretionary income to spend, specifically on charitable donations toward social welfare or other causes that the government is also funding.

In this respect, public sector expenditures for social welfare may reduce private sector giving for social welfare, thereby reducing the net effect of the government’s spending on those same causes. In certain cases, governments may exclusively tax the wealthy for social welfare projects aimed at benefiting the poor. This taxing of the wealthy to benefit the poor is popularly known as the Robin Hood effect. Additionally, the creation or expansion of public health insurance programs like Medicaid can have the effect of prompting those covered by private insurance to switch to the public option, which is another similar form of crowding out. Fewer customers for private health insurance companies can have the effect of decreasing the availability of private health insurance.

Crowding Out and Infrastructure

Another form of crowding out can occur because of government-funded infrastructure development projects, which can discourage private enterprise from taking place in the same area of the market by making it undesirable or even unprofitable. This often occurs with bridges and other roads, as government-funded development discourages companies from building toll roads or from engaging in other similar projects.

For example, if Build-It Infrastructure Corp. is thinking about building a bridge across the San Francisco Bay and has structured the project’s profit model around charging tolls for cars crossing the bridge, the announcement of a government-funded bridge project in the area will likely prevent Build-It’s project from taking place, as their toll bridge will likely not be able to compete with a free, publicly funded one.

In certain cases, government may also cause crowding out by entering into areas that were previously covered exclusively by private industry, which can include things like business grants and government investment. Traditionally, venture capital firms invest in new companies to help them grow and to increase the firm’s capital. With a reduced capacity to select their ideal companies, venture capital firms technically have a reduced capacity to make successful investments.

History of 'Crowding Out Effect'

The crowding out effect has been discussed for over a hundred years in various forms, much of which was before the modern global economy came to be. During this time, people thought of capital as being finite and confined to individual countries, which was largely the case due to low levels of international trading compared to the modern day. With much of a country’s wealth being retained within its borders, increased taxation for public works projects and other public spending could be directly linked to a reduction in the capacity for private spending, as less money was available. 

On the other hand, macroeconomic theories like Chartalism​ and Post-Keynesianism hold that in a modern economy operating significantly below capacity, government borrowing can actually increase demand by improving employment, thereby stimulating private spending as well. This process is often referred to as the “crowding in effect” or simply “crowding in.” The crowding in theory has gained some currency among economists in recent years after it was noted that, during the Great Recession of 2008 when the United States economy was well below capacity, enormous spending on the part of the United States federal government on bonds and other securities actually had the effect of reducing interest rates

For more on the Crowding Out Effect and the role of fiscal policy, check out A Look At Fiscal And Monetary PolicyA Look At National Debt And Government BondsThe U.S. National Spending And Debt and Giants Of Finance: John Maynard Keynes.

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