The crowding-out effect and the multiplier effect can be viewed as two contrary, or competing, possible impacts of government economic intervention funded by deficit spending.
In traditional economic theory, the crowding-out effect, to whatever extent it occurs, reduces the multiplier effect of deficit-funded government spending aimed at stimulating the economy. Some economists even theorize the crowding-out effect completely negates the multiplier effect, so that, in practical terms, there is no multiplier effect induced by government spending.
What is the Multiplier Effect?
The multiplier effect refers to the theory that government spending intended to stimulate the economy causes increases in private spending that additionally stimulate the economy.
In essence, the theory is that government spending gives households additional income, which leads to increased consumer spending. That, in turn, leads to increased business revenues, production, capital expenditures and employment, which further stimulates the economy.
Theoretically, the multiplier effect is sufficient enough to eventually produce an increase in total gross domestic product, or GDP, that is greater than the amount of increased government spending. The result is an increased national income.
What is the Crowding-Out Effect?
In theory, the crowding-out effect is a competing force to the the multiplier effect. It refers to government spending "crowding out" private spending by using up part of the total available financial resources. In short, the crowding-out effect is the dampening effect on private sector spending activity that results from public sector spending activity.
The crowding-out theory rests on the assumption that government spending must ultimately be funded by the private sector, either through increased taxation or financing. Therefore, government spending effectively uses up private resources, and it becomes a cost that has to be weighed against the possible benefits derived from it. However, it can be difficult to determine that cost, since it involves estimating the amount of economic benefit that the private sector could have seen if its resources weren't diverted to the government.
Part of the crowding-out theory also rests on the idea there is a finite supply of money available for financing, and that whatever borrowing the government does reduces private sector borrowing – and therefore may negatively impact business investments in growth. But the existence of flat currencies and a global capital market complicate that idea by bringing into question the very notion of a finite money supply.
In theory, since the crowding-out effect reduces the net impact of government spending, it correspondingly reduces the extent to which government stimulus spending efforts are multiplied.
There is an intense debate between economists, especially in the wake of massive government spending initiated after the 2008 financial crisis, as to the validity of both the multiplier effect and the crowding-out effect.
Classical economists argue the crowding-out effect is the more significant factor, while Keynesian economists argue the multiplier effect more than outweighs any potential negative impacts resulting from the crowding out of private sector activity.
However, both camps largely agree on one point: Government economic stimulus activities are only effective on a short-term basis. They believe that ultimately, economies cannot be sustained by a government that is perpetually operating deeply in debt.