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Crowding-Out Economic Theory: Definition, Types, and Examples

Crowding-Out Economic Theory

US economics revolves around making smart public investments, educating workers, and promoting fair and unbiased competition to lower costs and help small businesses flourish in the market. However, increased spending in public-sector investments can affect private-sector investments in various ways depending on factors like the level of composition and financing of the debt, which ultimately occurs when increased public-sector borrowing raises interest rates and reduces the availability of credit for private investors. 

It is also known as the crowding-out effect and can ultimately hamper economic growth and productivity in the long run. The crowding-out effect is a theory that explains the reduction in private-sector investment brought upon by increased government spending. According to this theory, when the nation’s economy is at full capacity, it leads to a rise in government borrowing. 

When the government spends more than usual, it increases the demand for loans and a rapid increase in government borrowings. This leads to a rise in interest rates and a decrease in the availability of funds for the private sector. Therefore, crowding out private investment with increased public sector activity. 

In this blog, we will discuss the crowding-out theory and how it impacts public investing and private investments, how it works and the various types of crowding-out effects. 

What is the Crowding Out Effect?

The crowding out effect is an economic theory that explains that an increase in public sector spending slows down or even eliminates private investments. The government requires extra revenue to spend more, it obtains it by raising taxes or borrowing through the sale of treasury securities

Higher taxes eventually lead to reduced income and spending by individuals and businesses in the private sector. Moreover, the sale of treasury securities can increase interest rates and borrowing costs which means reduced borrowing demand and spending. 

That being said, these public sector activities result in the crowding out of spending by individuals and companies of the private sector. 

However, if the economy is operating below full capacity or going through a phase of recession, the government’s increased spending will lighten the economy by increasing private investments, economic growth, and employment. 

How Does the Crowding Out Effect Work?

In layman’s terms, the crowding out effect is based on the supply and demand of money. According to this theory, if the government takes the initiative to raise revenue by increasing taxes or debt security sales, consumer and business spending in the private sector decreases. 

This ultimately leads to a potentially reduced income. Thus, the public sector crowds out the private sector investments by increasing their own. 

However, the crowding out theory also counters popular and renowned theories that argue that increased government during periods of recession or slow economic growth actually increases spending by consumers and businesses by putting more money in their pockets. 

One of the most popular types of crowding-out effect takes place when a well-established economy, like the USA, increases its borrowing and triggers a chain of events that results in a decrease in private sector spending. 

The sheer size and scale of the borrowing leads to a dramatic rise in interest rates. This diminishes the economy’s lending capacity and discourages businesses and companies from making capital investments. 

Most companies often fund capital projects through financing. The increased cost of borrowing makes profitable projects that are funded through loans cost-prohibitive. 

Types of Crowding-Out Effects

There are several types of crowding-out effects that impact the private sector. Let’s take a look- 

Economic

Economic stimulus benefits offered by government borrowing can be partially disturbed by a reduction in corporate capital spending. However, this is only the case when the economy is working at its full capacity. In this case, government stimulus is more effective when the economy is in a phase of recession or working below capacity. 

This can reduce the revenues collected through taxes and encourage the government to borrow even more money. This in turn can lead to a vicious cycle of borrowing and crowding out. 

Social Welfare

Indirect crowding can also take place because of social welfare. If the government raises taxes to introduce or implement a social welfare policy, companies and businesses in the private sector are left with discretionary income. This, in turn, reduces charitable contributions. 

In this case, the increase in expenditure on social welfare can reduce private sector contributions for social welfare, offsetting the government’s spending on the same issues. 

Similarly, the expansion of public healthcare programs can encourage those covered with private health insurance to switch to the public option. This will force private insurance companies to raise premiums, leading to further reductions in private investments. 

Infrastructure

Another common type of crowding-out occurs from government-funded infrastructure projects. This discourages private companies from launching similar infrastructure projects in the same niche as they will rarely trump the government. Moreover, corporate analysts might even indicate that investing in a particular project is not profitable, leading to a reduction in private investments. 

This often happens with bridges and roads as government-funded projects discourage companies from building-related infrastructures. 

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How to Measure Crowding-Put of Public Investment on Private Investment?

Here we will discuss some of the best indicators to measure the crowding out of public investment in the private sector. 

Interest Rate Spread

The interest rate spread is one of the most direct indicators of crowding out. It refers to the difference between the interest rate on public investments and the interest rate on private investments. The higher the spread, the more expensive it is for private investors to get loans or borrow money compared to the government. This, in turn, discourages private investments and also reduces the efficiency of capital allocation. 

However, this is not a perfect measure and also reflects various other factors such as inflation expectations, risk premia, and liquidity and preferences. 

Credit-to-GDP Ratio

Another common indicator of the crowding-out effect is the credit-to-GDP ratio. It refers to the ratio of total credit in the economy to the Gross Domestic Product. If the ratio is low, there is less credit available for private investment. A high public debt ratio can lower the credit-to-GDP ratio by absorbing a large share of domestic savings and crowding out private-sector borrowers from the credit market. 

However, it is also not considered a perfect measure as it can also be influenced by various other factors such as regulation, innovation, and financial development. 

Private Investment-to-GDP Ratio

The private investment-to-GDP ratio is also an indicator of the crowding-out effect. It refers to the ratio of private investment to the gross domestic product. A lower ratio means that private investments are contributing less to economic growth and development. The private investment-to-GDP ratio is lowered by high public debt, raising the cost of capital, reducing the expected returns, and creating instability and uncertainty. 

Much like other factors, it is also not a perfect measure and is influenced by a variety of other factors like business confidence, technological progress, and demand conditions. 

Fiscal Multiplier

Fiscal multiplier which refers to the ratio of the change in output to the change in government spending. A low Fiscal multiplier means that government spending is less effective in stimulating economic growth and generating income. A high public debt can lower the multiplier by offsetting the positive effects of government spending with the negative effects of higher interest rates, taxes, and deficits. 

Similar to other crowding-out effect indicators, the fiscal multiplier is also not a perfect measure and can be influenced by various factors like type, timing, and composition of government spending. It is also dependent on the state of the economy. 

Debt Sustainability

Another indicator of the crowding-out effect is debt sustainability. It is the ability of the government to service its debt liabilities without compromising the economic stability and policy objectives. The lower the debt sustainability, the higher the risk of restructuring, which can have negative consequences for private investment and growth. A high public debt can lower debt sustainability by increasing the interest payments, debt-to-GDP ratio, and vulnerability to shocks. 

On the other hand, debt sustainability can be increased by prudent financial management, structural reforms, and external support. 

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Crowding-Out Effect vs. Crowding-In Effect

While the crowding-out theory explains how increased government expenditure negatively affects the private sector, the crowding-in theory suggests that increased government expenditure positively affects the private sector. 

Crowding-OutCrowding-In
Increased spending in the public sector leads to a fall in private sector demand.Increased government spending in the public sector leads to a rise in private sector demand. 
Happens due to the rise in interest rates and prices.Happens mostly due to infrastructure development. 
Useful during economic expansionUseful during economic recession
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Examples of the Crowding Out Effect

Here are a few examples of the crowding out effect to help you understand how this economic theory works. 

Example 1

A renowned tech company is looking to borrow money to expand its Research and Development Wing to devise new technology capable of enhancing people’s lives. 

The company’s plan was to take out a loan of $5 million with an interest rate of 4%. However, during that time, interest rates started to soar and increased from 4% to 6%. This happened because the government decided to invest in various developmental projects and collect necessary funds through debt financing

As a result, the demand for loanable funds decreased the availability of funds and increased the interest rates. Because of the crowding-out effect, interest rates increased which made the private company rethink its investment decision. Hence, the company decided not to invest in the project at the time. 

Interest rates go up when the government decides to increase its spending due to the increase in aggregate demand. When there is an increase in aggregate demand, the prices of goods will also increase to compensate for the shift in demand. 

This example is the actual scenario of the crowding-out effect on investment. 

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Example 2

Suppose there is a private construction company that specializes in building alternative energy sources like solar and wind farms. If the government decides to spend on a renewable energy project like a solar or wind farm, the private construction company would be crowded out of the sector. 

As a result, the construction company would no longer be able to function in this sector and would reduce its spending on projects as they would no longer be profitable. 

Final Words: Is Crowding Out Good or Bad?

If crowding-out exists in an economy, it can be perceived as negative because it can negatively impact and slow down economic growth and activity. This happens as higher taxes reduce spendable income and increased government borrowing raises borrowing costs and reduces the demand for loans in the private sector. 

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Frequently Asked Questions(FAQs)

Q. What is the crowding-out effect on fiscal policy?

Ans. The crowding out theory suggests that the increase in government spending leads to a decrease in investments in the private sector. Crowding-out can be of different types, the most common type is when an increase in government spending due to the expansion of fiscal policies increases the demand for loans and leads to a rise in interest rates that decrease private spending.

Q. What causes a liquidity trap?

Ans. The liquidity tap means a scenario where clients prefer to hold onto their savings instead of making bank deposits on further investments. They believe that it would diminish the return during an economic recession. 

Q. Why is Crowding Out Important to Understand?

Ans. It is important to understand crowding-out as it contradicts a well-understood theory that government spending supports the economy and boosts private sector spending. 

Q. How Does Crowding Out Affect Aggregate Demand?

Ans. According to the crowding-out theory, it reduces aggregate demand as it discourages spending and the demand for loans because of higher interest rates and reduced income. 

Q. What is an example of crowding out?

Ans. Suppose the government increases taxes to balance the increased public spending activities. This, in turn, increases the tax liability of the public and companies, reducing the income earned by these entities, which makes them rethink their investments. The entities will crowd out from spending and investment plans.