Crowding Out Effect

Loading the player...

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.

RELATED TERMS
  1. Public-Private Partnerships

    A business relationship between a private-sector company and ...
  2. Keynesian Economics

    An economic theory of total spending in the economy and its effects ...
  3. Development Economics

    A branch of economics that focuses on improving the economies ...
  4. Economics

    A social science that studies how individuals, governments, firms ...
  5. Finance

    The science that describes the management, creation and study ...
  6. Corporate Finance

    1) The financial activities related to running a corporation. ...
Related Articles
  1. Economics

    Crowding Out Effect

    Crowding out effect is an economic term referring to government spending driving down private sector spending, and can have several more specific meanings.
  2. Economics

    The Austrian School Of Economics

    Investopedia explains: If you think economists are only concerned with numbers, check out the Austrian School, who are more like economic philosophers.
  3. Economics

    Understanding Supply-Side Economics

    Does the amount of goods and services produced set the pace for economic growth? Here are the arguments.
  4. Investing Basics

    Economic Indicators That Do-It-Yourself Investors Should Know

    Understanding these investing tools will put the market in your hands.
  5. Economics

    The Uncertainty Of Economics: Exploring The Dismal Science

    Learning about the study of economics can help you understand why you face contradictions in the market.
  6. Economics

    The History Of Economic Thought

    Economics is a vital part of every day life. Discover the major players who shaped its development.
  7. Retirement

    Bond Basics Tutorial

    Investing in bonds - What are they, and do they belong in your portfolio?
  8. Bonds & Fixed Income

    Advanced Bond Concepts

    Learn the complex concepts and calculations for trading bonds including bond pricing, yield, term structure of interest rates and duration.
  9. Fundamental Analysis

    The 3 Best Investments When Bull Markets Slow Down

    Find out why no bull market lasts forever, and why investors should shift their assets away from growth and toward dividends when stocks slow down.
  10. Economics

    Industries That Thrive On Recession

    Recessions are not equally hard on everyone. In fact, there are some industries that even flourish amid the adversity.
RELATED FAQS
  1. How does crowding out affect supply and demand in the private-sector?

    Crowding out decreases private-sector demand because the higher government borrowing causes an equivalent fall in private ... Read Full Answer >>
  2. How does the crowding out effect influence the multiplier effect of a government ...

    In traditional economic theory, the crowding-out effect, to whatever extent it occurs, reduces the multiplier effect of deficit-funded ... Read Full Answer >>
  3. Do budget deficits "crowd out" the market?

    Government deficits crowd out private investment, although the mechanism through which that occurs can be more or less direct. ... Read Full Answer >>
  4. What is the difference between fiscal deficit and federal debt, and which is worse?

    Fiscal deficit describes a government with expenditures that are greater than its revenues during a fiscal year. The federal ... Read Full Answer >>
  5. What's the difference between microeconomics and macroeconomics?

    Microeconomics is generally the study of individuals and business decisions, macroeconomics looks at higher up country and ... Read Full Answer >>
  6. Does dental insurance cover implants?

    Dental implants have become a widely used procedure in dentistry. Despite their popularity, however, they tend to not be ... Read Full Answer >>
Hot Definitions
  1. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  2. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  3. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  4. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  5. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center