Crowding out (economics)

Based on Wikipedia: Crowding out (economics)

Here's a puzzle that has haunted economists for centuries: when the government spends more money, does it help the economy grow, or does it accidentally strangle the very businesses it meant to help?

The answer, frustratingly, is "it depends." And understanding on what it depends turns out to be one of the most consequential questions in all of economics.

The Basic Idea: A Finite Pool of Money

Imagine a small town with exactly one bank. The bank has a limited amount of money to lend. Local businesses line up to borrow funds for new equipment, hiring, and expansion. Then one day, the town government shows up at the bank, wanting to borrow a massive sum to build a new community center.

What happens next?

The bank can only lend what it has. With the government demanding a large chunk of available funds, there's less left for everyone else. To ration the remaining money, the bank raises interest rates. Some businesses that would have borrowed at the old, lower rate now decide the loan isn't worth it. They shelve their expansion plans. They don't hire those new workers. They don't buy that new equipment.

This is crowding out in its simplest form. The government's demand for money "crowds out" private investment by driving up the price of borrowing.

But Is That Really How It Works?

The small-town bank story makes intuitive sense. But the global economy isn't a small town with one bank.

In the real world, savings don't stay neatly within national borders. Capital flows across oceans at the speed of an electronic transfer. A factory owner in Ohio can borrow money that originated from a pension fund in Tokyo or a sovereign wealth fund in Abu Dhabi. This international capital mobility, as economists call it, completely undermines the simple story of a fixed pool of money being divided up.

If the American government borrows more, it doesn't just compete with American businesses for American savings. It competes in a vast global market where trillions of dollars slosh around looking for returns. The impact on interest rates becomes much more diffuse, spread across the entire planet rather than concentrated in one country.

This is why many economists argue that crowding out, at least in its classic interest-rate form, is less powerful than it used to be. We don't live in the closed economies of the 1970s anymore.

When Crowding Out Bites Hardest

Context matters enormously.

Consider an economy running at full capacity. Every worker who wants a job has one. Every factory is humming along at maximum output. Every skilled electrician, software developer, and truck driver is already busy. Now the government decides to launch a massive infrastructure program.

Where will the workers come from? Where will the steel and concrete come from? Where will the engineers come from?

There's only one place: the private sector. The government must bid resources away from private companies. Wages rise. Material costs spike. Some private projects become unprofitable and get cancelled. The government's spending doesn't add to total economic activity so much as redirect it. Public construction replaces private construction. Government hiring displaces private hiring.

This is sometimes called "real crowding out," and it's almost impossible to avoid when the economy has no slack. You can't conjure workers and materials out of thin air.

When Crowding Out Barely Exists

Now consider the opposite scenario: a deep recession.

Unemployment is high. Factories sit idle. Construction workers nurse their coffees at home, waiting for the phone to ring with news of work. Companies are sitting on piles of cash but see no reason to invest when customers aren't buying.

In this environment, government spending doesn't compete with private activity. It fills a void. The construction workers the government hires weren't going to be hired by anyone else. The steel the government buys was just sitting in warehouses. Interest rates are already at rock bottom, so there's not much room for them to rise.

The late economist Laura D'Andrea Tyson made this point forcefully during the slow recovery following the 2008 financial crisis: when there's considerable excess capacity in the economy, government deficits don't crowd out private investment. Instead, the higher demand resulting from government spending can actually encourage additional private spending. Businesses see customers again. They see reason to invest. Rather than crowding out, you get "crowding in."

Think of it this way: if nobody's buying cars, an automaker isn't going to build a new factory no matter how cheap loans are. But if government spending puts money in people's pockets and they start buying cars again, suddenly that new factory makes sense.

The Role of the Central Bank

There's a crucial actor we haven't discussed enough: the central bank.

In the United States, that's the Federal Reserve. In Europe, the European Central Bank. In Japan, the Bank of Japan. These institutions control short-term interest rates and can dramatically influence whether crowding out happens.

When the government borrows more, it doesn't automatically raise interest rates. In fact, increased government spending initially injects money into the banking system, which can actually push short-term rates down. The question is how the central bank responds.

If the central bank believes the economy is running hot and inflation is a risk, it will raise interest rates to cool things down. This deliberate rate increase is what actually does the crowding out. Private investment drops not because of some mechanical shortage of funds, but because the central bank made a policy choice.

Conversely, if the central bank believes the economy needs stimulus, it can keep rates low even as the government borrows more. In this case, crowding out simply doesn't happen.

The 2008 financial crisis and its aftermath provided a dramatic real-world test. The U.S. government's borrowing exploded by hundreds of billions of dollars. Many predicted this would drive interest rates through the roof, crowding out private investment. Instead, interest rates fell to near zero and stayed there for years. The feared crowding out never materialized because the Federal Reserve wanted low rates to support the struggling economy.

A Detour Through Economic Diagrams

Economists love to think about these questions using two curves with memorable names: the IS curve (standing for Investment-Saving) and the LM curve (standing for Liquidity preference-Money supply). These curves describe how interest rates and total economic output interact.

The key insight is this: the steeper the LM curve, the more crowding out you get. A very steep LM curve means that when the government spends more, interest rates shoot up dramatically, choking off private investment. A very flat LM curve means interest rates barely budge, and crowding out is minimal.

In the extreme case of what economists call a "liquidity trap," the LM curve becomes perfectly horizontal. Interest rates are stuck at zero and can't fall any further. In this situation, government spending has its maximum impact with essentially no crowding out. Japan spent much of the past three decades in something like this condition. The United States and Europe found themselves there after 2008.

The International Twist

There's another channel through which government borrowing can affect the private economy, one that operates through international trade rather than domestic interest rates.

Here's how it works. When a government borrows heavily and this leads the central bank to raise interest rates, those higher rates attract foreign investors seeking better returns. Money flows into the country from abroad. But to buy domestic assets, foreigners first need to buy the domestic currency. This increased demand for the currency pushes up its value.

A stronger currency makes exports more expensive for foreign buyers and imports cheaper for domestic consumers. Exporters suffer. They're being "crowded out" not by competition for loans but by an unfavorable exchange rate.

The economists Robert Mundell and Marcus Fleming worked out this mechanism in the 1960s, and their framework remains influential today. It's a reminder that in a globalized economy, the effects of government policy can ripple outward in unexpected directions.

Beyond Finance: Crowding Out in Other Domains

Economists have borrowed the crowding-out concept and applied it well beyond interest rates and investment.

Health policy researchers worry about crowding out in public insurance programs. When the government creates or expands a program like Medicaid or the State Children's Health Insurance Program (known as SCHIP), the goal is to cover people who lack insurance. But sometimes, people who already have private insurance switch to the new public option instead. They were going to be insured either way. The program's impact on the uninsured is smaller than the raw enrollment numbers suggest.

This became a heated issue during debates over expanding children's health insurance in the late 1990s. Critics worried that generous programs would lure families away from employer-provided coverage. Defenders pointed out that most children enrolling genuinely lacked access to affordable private options. New Jersey, which extended eligibility to families earning up to three and a half times the federal poverty level, carefully tracked its program and identified only about fourteen percent of enrollees who might have had private coverage otherwise.

There's also evidence of crowding out in venture capital markets. When governments set up programs to fund startups and young companies, they may inadvertently discourage private venture capitalists from stepping in. Why take the risk if the government is already writing checks?

And behavioral economists have documented a subtler form of crowding out: financial incentives can crowd out intrinsic motivation. Pay people for donating blood, and some regular donors stop coming because the payment makes the act feel less like altruism and more like a transaction. This psychological crowding out operates through entirely different mechanisms than the financial kind, but the metaphor of one thing displacing another carries over.

The Charitable Giving Question

When governments expand social programs, do private charities shrink?

This question haunts debates about the welfare state. If the government feeds the hungry, will donors stop giving to food banks? If public housing expands, will charitable organizations that shelter the homeless find their funding drying up?

The evidence is mixed. Some studies find modest crowding out: private giving does decline somewhat when public programs expand. But the effect is rarely one-for-one. Government spending tends to increase total resources flowing to social needs, even if private charity contributes a somewhat smaller share.

The relationship can also work in reverse. Sometimes government programs legitimate a cause and make people more aware of a need, actually stimulating private giving rather than suppressing it.

What This Means for Policy

The crowding-out debate matters enormously for how we think about government's role in the economy.

If crowding out is powerful and pervasive, then even well-intentioned government spending might backfire. Every dollar the government spends could mean roughly one less dollar of private investment. The economy might end up no better off, just with a different mix of public and private activity.

If crowding out is weak or conditional, then government has much more room to maneuver. During recessions especially, deficit spending could genuinely boost the economy without displacing private activity.

The truth, as suggested by decades of research and real-world experience, lies somewhere in between and depends heavily on circumstances. Crowding out is real, but it's not automatic or universal. It matters whether the economy is at full employment or in recession. It matters how the central bank responds. It matters how integrated the country is with global capital markets.

Perhaps the most important lesson is that government spending on productive investments, such as infrastructure, education, and research, can expand the economy's long-run potential. Yes, building a highway might crowd out some private construction in the short run. But if that highway enables new commerce and economic development for decades to come, the crowding-out calculation looks very different.

A Controversy That Never Dies

Debates about crowding out have flared up during every major economic crisis of the past century.

After World War One, Britain slashed public spending under the austerity program known as the "Geddes Axe," partly from fear that government borrowing was harming the private economy. In the 1930s, John Maynard Keynes battled what he called the "Treasury view," the British government's position that public works spending couldn't reduce unemployment because it would simply displace private spending. During the stagflation of the 1970s, monetarist economists argued that government deficits were choking off productive investment. After 2008, the same arguments returned with renewed intensity.

Each time, the circumstances differed. Each time, economists argued about which channel of crowding out mattered most and whether it mattered at all. The debate continues because the underlying questions are genuinely difficult and because so much depends on details that are hard to observe in real time.

What we can say with confidence is this: the simple story of a fixed pool of savings being divided between government and private borrowers is too simple. The real world is messier, more interconnected, and more contingent. Crowding out exists, but it is neither inevitable nor uniform. Understanding when and how it operates remains one of the central challenges of economic policy.