Definition of crowding out 

– when government spending fails to increase

overall aggregate demand because higher government spending causes an
equivalent fall in private sector spending and investment.
Question: Why does an increase in public sector spending by the government
decrease the amount the private sector can spend?
If government spending increases, it can finance this higher spending by:

1. Increasing tax
2. Increasing borrowing
Impact of higher government spending on aggregate demand
1. Increasing tax. If the government increases tax on the private sector, e.g.
higher income tax, higher corporation tax, then this will reduce the
discretionary income of consumers and firms. Ceteris paribus, increasing
tax on consumers will lead to lower consumer spending. Therefore, higher
government spending financed by higher tax should not increase overall
AD because the rise in G (government spending) is offset by a fall in C
(consumer spending).
2. Increasing borrowing. If the government increases borrowing. It borrows
from the private sector. To finance borrowing, the government sell bonds
to the private sector. This could be private individuals, pension funds or
investment trusts. If the private sector buys these government securities
they will not be able to use this money to fund private sector investment.
Therefore, government borrowing crowds out private sector investment.
Resource crowding out
The second type of crowding out is simply the fact that if the private sector lends
money to the government they have less money to invest in private sector
projects.
A production possibility frontier is useful for showing the idea of crowding out. If
we are on the PPF curve at Point A and we increase government spending it
leads to fall in private sector spending.

Furthermore, it is argued that the private sector investment tends to be more

efficient than the public sector investment. Therefore, the economy is worse off
for government borrowing.

Financial crowding out

 EU
bond yields rose in 2011/12 due to higher borrowing and no effective lender of last resort
This is the term used to describe how government borrowing can cause higher
interest rates. If the government needs to sell more securities, it may have to
increase interest rates on its bonds to attract people to buy. For example, in the
EU, bond yields rose in 2011 because markets were worried about levels of EU
debt. Therefore, the increased government borrowing was at the expense of
higher interest rates on government debt. These higher interest rates on bonds
lead to higher interest rates elsewhere in the economy and are likely to
discourage private sector investment and spending.

Crowding out doesn’t always occur

It is important to bear in mind crowding out doesn’t always occur – it depends on
the state of the economy.
  If the economy is below full capacity, then we can have more government
spending and more private sector spending.
Keynesians again argue that in a recession and liquidity trap, there is no
crowding out because the government is merely spending unused resources.
Keynesians argue that in a liquidity trap the LM curve is elastic. This means
increased government spending doesn’t increase interest rates.
Another way of thinking about a recession is that the rise in government
borrowing is merely to offset the rise in private sector saving.
This graph shows that in 2008-2012, there is a sharp rise in private sector
saving. This is matched by an equivalent rise in government borrowing.

Crowding out and bond yields

 Du
ring great recession (2008-15) Higher debt in the UK led to lower bond yields
In a recession, the government can often borrow more without interest rates
rising. For example, in the UK 2009-13, despite higher borrowing – bond yields
fell because people wanted to save money in bonds rather than invest.
Therefore, there was no financial crowding out.

Also, as Keynes argued – in a recession – the private sector has idle resources
(due to more saving). Therefore, government borrowing is effectively making use
of these idle resources. Financial crowding out is more likely to occur when the
economy is growing and is close to full capacity already.

Depends on the state of the economy

When the economy is growing strongly, the government will have more
competition from other private sector investments. Therefore government bonds
yields will have to rise to attract savings from other investment projects.

Economists who have suggested Crowding Out

Milton Friedman was generally dismissive of expansionary fiscal policy. He

argued that, although there may be a temporary boost, in the long-term debt-
financed government spending would cause crowding out. Milton Friedman noted
that debt supported government spending leads to “a reduction in the physical
volume of assets created because of lowered private productive investment.”
(Crowding Out)
Frank Knight. Knight is credited with the theory that demand for investment is
interest-elastic. Therefore, even a very small increase in interest rates (from
financial crowding out) could cause a very large fall in private sector investment.
John M Keynes. In his General Theory, Keynes stated that if the economy was
close to full capacity expansionary fiscal policy would cause crowding out.
Robert Baro. Baro is credited with developing the theory of Ricardian
equivalence. The idea public debt issuance is equivalent to higher taxes – i.e.
deficit spending is very limited in increasing real GDP.