When a government increases its total borrowing, this can have a significant impact on the economy in the form of a rise in the real interest rate of that economy. As a result, the lending capacity of the economy is exhausted, and firms are less willing to engage in new enterprises. This is because enterprises often rely on finance to be able to afford these types of expenditures; as the opportunity cost of relying on financing rises, investments that would otherwise be financially advantageous become overly expensive and, hence, unprofitable. Which, overall, often leads to a reduction in the amount of activity in the private sector.
This is referred to as the “crowding out” effect.
Crowding Out Effect: Definition
Economically, the crowding out effect occurs when the government and the private sector compete for the same revenues or other resources. When the economy is unable to meet the demands of both groups, the government typically has priority over the resources. This makes it impossible for private company to secure all of the funds or raw resources it desires. When the government consumes more from the private sector, interest rates frequently increase substantially. In turn, this increase in interest rates can hinder economic activity.
In order to increase spending, governments must either raise taxes or borrow money, generally by issuing bonds. If the government raises taxes, people and businesses may be subject to greater income and sales taxes, as well as corporate taxes. As a result, individuals and companies have less disposable income.
If the government borrows instead, it does so by issuing bonds. The crowding-out argument posits that if investors purchase government bonds, they have less cash to invest in private sector initiatives and investments. Additionally, the government may increase bond interest rates to increase their appeal to investors. This rise might result in increased interest rates for loans and other economic sectors. When the cost of borrowing increases, demand falls, resulting in less borrowing and spending by individuals and businesses.
In practice, crowding out is typically an issue when the government places a significantly greater demand than normal on the lending or industrial capacity of an economy.
Typical occurrences of this phenomenon include:
- Conflict-related times
- Inflationary times
- Fiscal imbalances
How the Crowding Out Effect Plays Out
The principle behind the crowding-out effect is derived from the economic relationship between supply and demand. According to this school of thought in economics, prices go down when there is an abundance of supply or when there is a lack of demand, and vice versa. In this situation, the money supply and demand are both affected by the expenditures of the government.
Considering the possibility that the government would opt to undertake an expansionary fiscal policy in the event that the economy enters a recession. The corporation takes out loans in order to finance the expansion of their spending. This results in a rise in the need for financial capital. If private savings and foreign investment continue at their current levels, there will be less cash available for private investment.
Rates of interest are a factor that has some bearing on this. The cost of capital, measured in terms of interest rates, tends to rise in tandem with rising demand for it. As a direct result, higher interest rates reduce the allure of taking out a loan. For this reason, businesses that may have financed the construction of a new plant with a loan might decide against doing so. Alternately, a person who was intending to seek a home equity loan in order to finance house renovations can change their mind and choose not to do so.
The borrowed money will eventually need to be repaid by the government as well. Unless future spending is brought under control, the government will be forced to fund repayment through increases in taxation. Businesses and individuals may choose to reduce their expenditure now in order to preserve more money in preparation for future increases in tax rates. Additionally, higher interest rates result in bigger returns on investments made through savings. Spending by the government has, in the end, “squeezed out” spending by private entities.
Different Types of Crowding Out
Interest rates and the desire for money are the basic illustration of the crowding out phenomena. But there are other forms of crowding out that might occur.
- Financial – The most prevalent type is financial suffocation crowding. This occurs when the government's desire for extra borrowed cash produces an increase in interest rates, so stifling private sector investment.
- Resource – The phenomenon of resource crowding out can occur when the government purchases a considerable amount of a given good's supply, making it impossible for the private sector to achieve its production deadlines. During times of conflict, the government frequently prioritizes the manufacture of weaponry and other military equipment. This might result in a shortage of materials in the larger economy.
- Infrastructure – In market-based economies where both the government and private sector supply infrastructure services, friction can arise. Suppose the government spends more in transportation-related infrastructure such as ports, trains, and postal services. This might deter private enterprises from offering these services, as it can be difficult to compete with a government-run company, whose operations are managed with less emphasis on profit.
Crowding Out Effect – Main Takeaways
If the crowding out effect has the effect of erasing a portion of the shift in aggregate demand caused by an increase in government expenditure, it may impede fiscal policy's ability to stimulate economic development. This dilemma is exacerbated if the government spends more on consumption goods than on investment items. Substituting government consumption for private investment may be acceptable in the short term, but it has the long-term effect of hindering certain developments.