Crowding Out Effect (Economic Theory)

What Is the Crowding Out Effect?

The crowding out effect is an economic theory arguing that rising public sector spending drives down or even eliminates private sector spending.

Understanding the Crowding Out Effect

One of the most common forms of crowding out takes place when a large government, such as that of the U.S., increases its borrowing and sets in motion a chain of events that results in the curtailing of private sector spending. The sheer scale of this type of borrowing can lead to substantial rises in the real interest rate, which has the effect of absorbing the economy's lending capacity and of discouraging businesses from making capital investments.

Companies often fund such projects in part or entirely through financing, and are now discouraged from doing so because the opportunity cost of borrowing money has risen, making traditionally profitable projects funded through loans cost-prohibitive.

Large governments increasing borrowing is the most common form of crowding out, as it forces interest rates higher.

The crowding out effect has been discussed for over a hundred years in various forms. During much of this time, people thought of capital as being finite and confined to individual countries, which was largely the case due to lower volumes of international trade compared to the present day. In that context, increased taxation for public works projects and public spending could be directly linked to a reduction in the capacity for private spending within a given country, as less money was available.

The Crowding Out Effect vs. Crowding In

On the other hand, macroeconomic theories such as Chartalism and Post-Keynesian posit that government borrowing, in a modern economy operating significantly below capacity, can actually increase demand by generating employment, thereby stimulating private spending as well. This process is often referred to as "crowding in."

The crowding in theory has gained some currency among economists in recent years after it was noted that, during the Great Recession of 2007–2009, massive spending on the part of the federal government on bonds and other securities actually had the effect of reducing interest rates.

Types of Crowding Out Effects

Economies

Reductions in capital spending can partially offset benefits brought about through government borrowing, such as those of economic stimulus, though this is only likely when the economy is operating at capacity. In this respect, government stimulus is theoretically more effective when the economy is below capacity.

If this is the case, however, an economic downswing may occur, reducing revenues the government collects through taxes and spurring it to borrow even more money, which can theoretically lead to a vicious cycle of borrowing and crowding out.

Social Welfare

Similarly, the creation or expansion of public health insurance programs such as Medicaid can prompt those covered by private insurance to switch to the public option. Left with fewer customers and a smaller risk pool, private health insurance companies may have to raise premiums, leading to further reductions in private coverage.

Infrastructure

Another form of crowding out can occur because of government-funded infrastructure development projects, which can discourage private enterprise from taking place in the same area of the market by making it undesirable or even unprofitable. This often occurs with bridges and other roads, as government-funded development deters companies from building toll roads or from engaging in other similar projects.

Crowding Out Effect Example

Suppose a firm has been planning a capital project, with an estimated cost of $5 million and a return of $6 million, assuming the interest rate on its loans is 3%. The firm anticipates earning $1 million in net income (NI). Due to the shaky state of the economy, however, the government announces a stimulus package that will help businesses in need but will also raise the interest rate on the firm's new loans to 4%.

Because the interest rate the firm had factored into its accounting has increased by 33.3%, its profit model shifts wildly and the firm estimates that it will now need to spend $5.75 million on the project in order to make the same $6 million in returns. Its projected earnings have now dropped by 75% to $250,000, so the company decides that it would be better off pursuing other options.