Crowding Out vs. Crowding In – Financial Markets & Public Policy
Crowding out occurs when government borrowing leads to higher interest rates, making it more expensive for the private sector to borrow and invest, potentially stifling economic growth.
Conversely, crowding in happens when government spending catalyzes private investment – particularly when it enhances public infrastructure or stimulates demand that the private sector can meet.
Effective public policy must balance these two forces to avoid dampening private sector activity while leveraging government spending to boost economic development.
Key Takeaways – Crowding Out vs. Crowding In
- Crowding out can increase borrowing costs for the private sector.
- Can potentially stifling private investment when government spending rises.
- Crowding in can enhance private sector productivity and investment.
- Government spending that stimulates economic activity.
- Policymakers must balance fiscal initiatives to avoid deterring private investment while aiming to catalyze economic growth.
Crowding Out: The Challenge for Private Investment
When governments borrow heavily to fund their deficits, they can drive up interest rates.
Borrowing creates debt (mostly bond issuance).
At a point, when there are too many bonds relative to the free market’s demand for them, that increases yields (interest rates).
This rise makes borrowing more expensive for companies and individuals.
This can lead to a reduction in private-sector spending.
In financial markets, this phenomenon is known as crowding out.
Crowding Out in Bond Markets
Evidence of crowding out appears most notably in bond markets.
As governments issue more debt, the bonds the deficits produce absorb a portion of the capital their own spending made available to the public.
Think of it this way – when the government spends domestically, that’s money in the real economy.
However, when the government issues bonds to pay for the deficits, that takes money back out.
That money, in turn, isn’t being used on spending in the real economy (which is other people’s incomes, and so on).
So, whatever isn’t wanted by the free market means yields have to go up.
Consequently, private issuers must offer higher returns to attract investors, raising their costs of capital.
This is the basis of how all investments compete with each other – cash, bonds, stocks, private equity, venture capital, etc.
This situation can lead to decreased investment in sectors like housing, business expansion, and research and development, and slowing economic growth.
Inflation
Inflation can be another side effect.
If a government borrows too much, it might lead to much spending relative to the supply of goods and services.
High inflation can erode purchasing power and further discourage private investment, as the future returns on investments become more uncertain.
Moreover, if the central bank buys the excess bonds that aren’t wanted by the free market, this keeps rates artificially low.
This can lead to more private sector credit creation than would otherwise be available without central bank intervention and inflation via that route.
Crowding In: The Potential for Public Investment to Stimulate
Conversely, crowding in occurs when government spending stimulates private-sector investment.
This can happen if government expenditures, like infrastructure projects, improve the productivity of the private sector.
Better roads, ports, and telecommunications can lower costs for businesses and spur economic activity.
Another pathway for crowding in is through public-private partnerships.
By leveraging government funds to attract private investment, these collaborations can amplify the impact of public spending.
Furthermore, when government spending increases demand for products and services, private companies may boost their investments to meet this new demand.
The Role of Monetary Policy
Monetary policy helps in balancing crowding out and crowding in effects.
Central banks adjust interest rates to change the incentives between borrowers and creditors.
This manages the economy’s overall demand.
But persistently low interest rates can inflate asset bubbles, leading to unsustainable increases in asset prices.
Too-high interest rates will hurt economic activity.
Careful calibration is needed to ensure that monetary policy supports economic growth without inducing excessive risk-taking in financial markets.
Implications for Public Policy
Policymakers need to be aware of the crowding out and crowding in effects when designing fiscal policies.
Deficit-financed spending may be counterproductive if it leads to crowding out – particularly during periods when the economy is close to full capacity (low employment rates is a common indicator).
During such times, tax-financed spending or spending cuts might be more appropriate to avoid overheating the economy.
In times of recession or when there is slack in the economy, government spending can be a tool to crowd in private investment.
With low demand from the private sector, government spending can kickstart economic activity without pushing up interest rates.
Traders’ Perspective
Investors and traders must also understand crowding out and crowding in dynamics.
The nature of government spending and the economic context can offer clues about future interest rate movements, inflation, and the overall investment climate.
For example, in an economy with lots of slack and lots of (current or upcoming) central bank stimulation, buying equities and riskier assets might be a better play because such an environment is good for those types of assets.
In a big booming economy with lots of inflation, equities and riskier assets will generally be less good because central banks will want to tighten and slow things down.
In the end, it’s about how things transpire relative to what’s discounted in.
Knowledgeable traders can adjust their portfolios accordingly, potentially reducing risks and capitalizing on opportunities presented by government spending patterns.
Crowding Out Example & Calculation
This occurs when increased government spending leads to higher interest rates, which in turn makes it more expensive for the private sector to borrow money.
Consequently, private investment is reduced because of these higher costs.
Example
The government decides to build new infrastructure and funds it by borrowing money.
As the government borrows more, it competes with the private sector for the same pool of savings.
The free market doesn’t want those quantities of bonds (to fund the spending) at the current rates.
When the market eventually clears, this pushes interest rates up from 5% to 7%.
Calculation
If a business was planning to take out a $1 million loan to expand operations, the interest cost at 5% would have been $50,000 per year.
At 7%, the interest cost increases to $70,000 per year.
The higher interest rate may lead the business to cancel or delay the expansion.
Accordingly, private investment is crowded out.
In other words, a project that would have happened no longer happens.
Crowding In Example & Calculation
This occurs when government spending leads to an increase in economic activity that stimulates more private-sector investment.
This can happen if government spending makes the private sector more productive – e.g., by improving infrastructure or increasing education levels (in a cost-effective way).
Example
The government spends on improving public transportation.
This reduces the commuting time for workers, leading to increased productivity.
Calculation
Assume the average worker earns $25 per hour and commutes 2 hours a day.
With the improved transportation, commuting time is reduced to 1 hour.
This gives the worker an extra hour for productivity, potentially adding $25 to the economy per day per worker.
If 100,000 workers are affected, this adds $2,500,000 to the economy daily, potentially increasing demand for goods and services, and encouraging private companies to invest more to meet this demand.
These examples are simplifications, as the actual economic impact of government policy can be influenced by many other factors and requires complex and multi-order analysis to fully understand.
For a more in-depth example, please see here.
Conclusion
The interplay between crowding out and crowding in is complex and depends heavily on the current state of the economy and the specifics of government policy.
Both concepts highlight the balance between the public and private sectors in promoting economic growth.
Understanding these dynamics is important for both policymakers and market participants who must figure out how government interventions impact the real economy and markets.