In a market downturn, recession, or depression, governments usually intervene in the economy to help stimulate growth and provide funding and assistance where it is strongly needed. There are many approaches to stimulating the economy by the government that are supported by different economists; the crowding-out effect and the multiplier effect being two options. Determining which stimulus option is the best depends on a variety of factors that relate to both the domestic economy as well as the global one.
The crowding-out effect and the multiplier effect can be viewed as two competing impacts of government economic intervention that are 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 that 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 stimulates 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 the total gross domestic product (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 for the multiplier effect. It refers to government "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 that 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 that the crowding-out effect is the more significant factor, while Keynesian economists argue that 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.
The Bottom Line
The crowding-out and multiplier effect theories are two opposing approaches to government intervention with the goal to stimulate the economy. They are both forms of deficit funding, which result in an increase in spending by the government. How much government spending and the source of government funds are the key debate between proponents and critics of both.
Both theories have their advantages and disadvantages, but determining the best choice requires a thorough analysis of the specific causes of a declining economy, the role of a global market, and other specific financial metrics in play.