What is the crowding-out effect?
Crowding-out is an economic theory arguing that increasing public sector spending lowers or even eliminates private sector spending.
Key points to remember
- The crowding-out effect suggests that increased spending in the public sector lowers spending in the private sector.
- There are three main reasons for the crowding-out effect: the economy, social protection and infrastructure.
- Crowding, on the other hand, suggests that public borrowing can actually increase demand by creating jobs, thereby stimulating private spending.
How the crowding-out effect works
One of the most common forms of foreclosure occurs when a large government, like the United States, increases its borrowing. The sheer size of these loans can lead to substantial increases in the real interest rate, which in turn absorbs the lending capacity of the economy and discourages businesses from investing capital.
Since companies often finance such projects partly or entirely through financing, they are now discouraged from doing so because the opportunity cost of borrowing has increased, making traditionally profitable projects funded by loans at a prohibitive cost.
The crowding-out effect has been discussed for over a hundred years in different forms. For much of this period, people believed that capital was limited and limited to each country, which was largely the case due to lower volumes of international trade than today. In this context, increased taxation of public works projects and public spending could be directly linked to a reduction in the capacity for private spending in a given country, because less money was available.
On the other hand, macroeconomic theories such as chartalism and post-Keynesianism argue that in a modern economy operating well below capacity, public borrowing can actually increase demand by generating jobs, thereby stimulating private spending. This process is often called “crowding”. This theory has gained ground among economists in recent years after finding that during the Great Recession, massive spending by the federal government on bonds and other securities actually reduced interest rates.
Large governments – like the United States – increasing borrowing is the most common form of foreclosure, which drives up interest rates.
Types of foreclosure effects
Reductions in capital spending can partially offset the benefits of public borrowing, such as those of economic recovery, although this is likely only when the economy is operating at full capacity. In this regard, the stimulus of public authorities is theoretically more effective when the economy is below its capacity.
If this is the case, however, an economic slowdown may occur, reducing the revenue the government collects through taxes and encouraging it to borrow even more money, which can theoretically lead to a vicious cycle of borrowing and foreclosure.
Eviction can also take place because of social welfare, albeit indirectly. When governments raise taxes to introduce or expand welfare programs, individuals and businesses are left with less discretionary income, which can reduce charitable contributions. In this regard, public sector spending on social protection can reduce private sector donations for social protection, offsetting government spending on these same causes.
Likewise, the creation or expansion of public health insurance programs like Medicaid may encourage people covered by private insurance to switch to the public option. Staying with fewer clients and a smaller pool of risk, private health insurance companies may have to increase their premiums, which would lead to further reductions in private coverage.
Another form of foreclosure can occur due to government-funded infrastructure development projects, which can discourage private enterprise from expanding in the same market area by making it undesirable or even unprofitable. This often happens with bridges and other roads, as government-funded development discourages companies from building toll roads or engaging in other similar projects.
Example of crowding out
Suppose a company plans a capital project with an estimated cost of $ 5 million and a return of $ 6 million, assuming the interest rate on its loans remains at 3%. The company plans to earn $ 1 million in net income. However, due to the fragile economy, the government is announcing a stimulus package that will help businesses in need, but will also raise the interest rate on new business loans to 4%.
Since the interest rate that the company had factored into its accounting increased by 33.3%, its profit model changes enormously and the company estimates that it will now have to spend $ 5.75 million on the project to generate the same $ 6 million in revenue. Its expected profits have now dropped 75% to $ 250,000, so the company decides that it would be better to pursue other options.