Government deficits crowd out private investment, although the mechanism through which that occurs can be more or less direct. The crowding out is in a relative, not absolute sense. Like any other economic good, investment capital is scarce. Any government bonds issued to pay for a deficit are purchased with investment funds that might have otherwise gone toward private investment.

If the government decides to raise taxes to finance a deficit, those additional taxes will further discourage private investment. Should the government decide to monetize the debt, the cost-of-living increases will also eat at savings and investment.

Crowding out also occurs in the market for loanable funds in general. Government bonds are a form of debt that has less counterparty risk than even the safest government bonds. When new government bonds are introduced, risk-averse investors are pulled away from other forms of safe income securities. This also raises the rate of interest that competing bonds have to offer. As with total private investments, these changes are relative rather than absolute.

Crowding Out, Interest Rates and Small Businesses

One of the more controversial alleged effects of government deficit spending relates to small business lending. Critics of expansionary fiscal policy argue that the real interest rate (not the market interest rate) is artificially inflated by large deficits. This, they assert, disproportionately affects small business lenders. The superabundance of cheap loans makes it easy for the government to borrow, but hard for individuals and small companies to survive marginal increases in the real rate.

Many academics and policy analysts contend that deficits disproportionately affect small businesses. Others argue that it's theoretically possible for the real interest rate to push away some lenders, but that loose monetary policy can help make up for any negative impact.

Interest rates do not necessarily need to rise to present this type of opportunity cost from fiscal deficits. The new real rate of interest need only be higher than it otherwise would have been without the government crowding out effect.

The Fallacy of Crowding In

Some proponents of fiscal deficits counter that, while crowding out is possible in financial markets, there is an opposite effect as well. This theory, known as "crowding in," argues that government spending will create such an increase in aggregate demand that the private sector has to ramp up production. This added production requires that additional capital be invested.

This argument is an extension of the traditional multiplier effect, whereby a dollar spent from government creates more than a dollar's worth of growth in gross domestic product (GDP). Those who disagree with this argument see several statistical flaws in it. They argue that the most obvious is that businesses cannot conjure investment capital just because aggregate demand is stronger. Instead, they believe it is more likely that the cost of capital will rise and that certain businesses will profit at the expense of others.