Download The Interdependence of Markets

Trends in Public Expenditure
And the crowding-out debate
From 1900 to the mid 1970s, general government expenditure (GGE) as a percentage of GDP
rose substantially. The rise, however, was not steady. On occasions, such as during the First
and Second World Wars, the level of GGE rose dramatically (but without returning
afterwards to previous levels).
50
Annual growth rate (%)
48
46
44
42
40
38
36
34
1970
1975
1980
1985
1990
1995
2000
Figure 1 UK general government expenditure as % of GDP
But after 1975, as Figure 1 shows, the trend turned downwards. In 1989 GGE as a percentage
of GDP was 39.8 per cent – its lowest level for 22 years. However, the deep and protracted
recession experienced by the UK in the early 1990s pushed expenditure rates back upwards
again to reach 45.4 per cent by 1993. Nevertheless, with continued economic growth since
then, the rate has progressively fallen, to stand at 37.7 per cent in 2000. However, in absolute
terms, GGE is still rising. It rose from £256.2 billion in 1981 to £339.9 billion in 2000, both
in 2000 prices..
Figure 2 shows that the four largest areas of GGE are social protection, health, education
and defence. Only defence has declined as a percentage of GGE (thanks to the ending of the
‘cold war’).
Attempts to control public expenditure since 1979
As Chapter 22, section 3 shows, Conservative governments in the 1980s and 1990s adopted a
number of tough measures to reduce the level of public expenditure (or to improve its
efficiency).
But despite the Conservative government’s desire to achieve savings in public
expenditure, most of the cuts were only at the margin. In real terms, GGE continued to rise.
Of all the government’s budgets, only housing, cut by 67 per cent between 1979 and 1990,
was dramatically reduced. It is only by trimming the big four: social security, health,
education and defence, which together account for 70 per cent of all spending, that GGE can
be significantly reduced. If, at the same time, there is a desire to improve public services in
both quantity and quality, a commitment of the Labour governments since 1997, any
trimming becomes very difficult. All that can be done is to focus on improving efficiency.
But the scope for efficiency gains, is limited, given the push to make such gains over the past
20 years.
Why is controlling public expenditure seen as such an important economic goal? The
answer lies in what is known as the ‘crowding-out debate’.
The crowding out debate
If increased government expenditure is used to stimulate output and employment, will the
effect be neutralised by crowding out? Will, for example, a programme of public works to
bring the economy out of recession merely lead to a reduction in private expenditure? To
answer this, it is important to distinguish two types of crowding out: resource crowding out
and financial crowding out.
Resource crowding out. This is when the government uses resources such as labour and raw
materials that would otherwise be used by the private sector. This would clearly be possible if
the economy were operating near full capacity. Workers cannot be in two places at once. If
they work for the government, they cannot at the same time work for a private company.
The argument is far less convincing, however, if there is slack in the economy. If the
government merely mobilises otherwise idle resources, there need be no reduction in privatesector output. Quite the opposite: if there is a growth in public-sector output and employment,
this will stimulate a demand for goods produced by the private sector too. If these privatesector firms have spare capacity, they will respond by producing more themselves. This is the
argument put forward by Keynesians: extra aggregate demand will stimulate extra production.
Financial crowding out. This occurs when extra government spending diverts funds from
private-sector firms and thus deprives them of the finance necessary for investment.
If the government spends more (without raising taxes or printing more money) it will have
to borrow more. In order to attract people to buy government securities or put their money in
National Savings, the government will have to offer higher rates of interest. Private
companies in turn will then have to offer higher rates of interest themselves in order to attract
funds. Alternatively, if they borrow from banks, and banks have less funds, the banks will
charge them higher interest rates. Higher interest rates will discourage firms from borrowing
and hence discourage investment.
In short, if the government spends more money, there will be less money for the private
sector to spend.
The weakness with this argument is that it assumes that the supply of money is fixed. If
the government spends more but increases the amount of money in the economy, it need not
deprive the private sector of finance. Interest rates will not be bid up.
But would not that be inflationary? No, say Keynesians, not if there are idle resources and
hence the extra money can be spent on extra output. Only if resource crowding out takes
place would it be inflationary.
What if the government reduces its expenditure: will this result in a release of resources and
funds, and will this lead to extra private expenditure? This is an even more contentious claim,
given that a successful reduction in government expenditure would lead to a direct reduction
in aggregate demand, whereas any fall in interest rates, made possible by the reduction in
government borrowing and the consequent release of funds to the private sector, would only
stimulate private investment expenditure if there was confidence that the economy would
expand.
Question
What is the connection between financial crowding out and resource crowding out?