Crowding out effect

Crowding out effect
See also
Free Reserves Interventionism Savings plan Austrian business cycle theory Demand shock Eurocredit Currency crisis Monetarism Hyman Minsky

Crowding out effect is the consequence of changes made by the government to fiscal policy that affect private investment and consumption. There are two types of crowding out; resource and financial, and there are two stages of crowding out; partial and complete. Resource crowding out occurs when the government uses up resources that would otherwise be used by the private sector, and financial crowding out occurs when the government spends more than it earns in tax revenues. By spending more than it earns the government is left with a budget deficit that needs to be made up by either raising taxes or borrowing. Borrowing causes the liquidity preference of money to rise.

Considerations of crowding out effect in economics

In crowding out private investors, economic productivity tends to take a rather immediate downturn as government spending is rarely aimed at construction of new factories, production of new consumer products, or the propensity for creating jobs. Granted, there are certain private investors given financial incentive by the government (i.e. Boeing with its defence contracts), but the ultimate goal of government borrowing is to maintain the status quo of the economy rather than actually stimulate further growth. The fatal flaw to the supposed solution of borrowing is that it only accounts for the short-term results and ignores the more than likely potential of augmenting the national deficit.

Crowding out effect prevention

Crowding out hampers the economy when a government crowds out private investment simply to fund more irresponsible spending habits, it does not just affect that particular country any more. Now that we live in an age when financial markets are hopelessly interconnected, the gamble of employing behaviour that will trigger the crowding out effect is no longer economically viable. While many economists still speculate about the validity of the crowding out theory, the best solution to eschewing its ramifications is for governments of every nation to start managing budgets as though they were tangible and stop looking at them from the perspective of a society dependent upon borrowing, loans and using credit.

References

• Andreoni, J. (1993). An experimental test of the public-goods crowding-out hypothesis. The American Economic Review, 1317-1327.
• Buiter, W. H. (1977). "Crowding out" and the effectiveness of fiscal policy. Journal of Public Economics, 7(3), 309-328.
• The "Crowding Out" of Private Expenditures by Fiscal Policy Actions, Roger W. Spencer & William P. Yohe, 1970.
• The Effects of Government Deficits: A Comparative Analysis of Crowding Out (Essays in international finance), Charles E. Dumas, Princeton Univ Intl Economics, October 1985
• The crowding-out effect in a macro model with both government and private sector financing constraints, Federal Reserve Bank of New York (1975)

Author: Vira Lysovets