Download The Crowding-out Effect

The Crowding-out Effect
When public expenditure replaces private
Critics of the use of government expenditure to stimulate output and employment
often refer to the problem of crowding out. In its starkest form, the argument goes like
this.
There is no point in the government embarking on a programme of public works to
bring the economy out of recession. If it attempts to spend more, it can do so only by
reducing private expenditure. The effect on total spending will be zero. This crowding
out can take two main forms.
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. If the economy is operating near full
capacity, then if resources are used by the government, they cannot at the same time
be used by private companies.
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
private-sector output. In fact, if private-sector firms have spare capacity, they will
respond to the higher demand by producing more themselves: 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 and will therefore have to offer higher rates of interest. Private
companies will then have to offer higher rates of interest themselves in order to attract
funds. Alternatively, if they borrow from banks, and banks have fewer funds, the
banks will charge them higher interest rates. Higher interest rates will discourage
firms from borrowing and hence discourage investment.
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 that not be inflationary? 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.
Question
Could resource crowding out take place at less than full employment?
Fiscal and monetary policy together
If fiscal and monetary policies are used together, they are much more likely to be
successful. For example, if there is a recession, the government may cut taxes or
increase government expenditure in order to expand aggregate demand. This could
lead to crowding out, however, unless the central bank simultaneously pursues an
expansionary monetary policy, so that any increase in the public-sector deficit is
financed by an expansion in the money supply. The central bank could go further and
actively cut interest rates.
The policies reinforce each other. The expansionary monetary policy helps to ensure
that increased public borrowing is not at the expense of private-sector consumption
and investment. The expansionary fiscal policy helps to ensure that increased money
is actually spent.