Crowding Out

Two words explain all you need to know about our national economic debate.  These words have the instant appeal of common sense. 

Economists worldwide know the words, yet a few of them, seemingly the more vocal ones, mysteriously reject the truth the words describe.  This rejection confounds because the words simplify our national discussion by demonstrating how borrow and spend policies don't add jobs, how such policies in fact subtract jobs.  This fact precludes any need for the debate to devolve into name calling, attribution of good or bad intent, or the stoking of class envy.  This fact precludes the necessity of any debate at all. 

The two words are crowding out.  The concept is well established and the definition straightforward.  Crowding out is "any reduction in private consumption or investment that occurs because of an increase in government spending."

An example may help.  Assume a family of four has four apples, resting ripely in the family fruit bowl.  Each family member can reasonably expect to eat an apple, whether that family member is the smallest member with the most expected growth or the largest with many pounds to shed.  If apple-loving friends from out of town visit, no longer is it reasonable for each family member to expect a whole apple (at least not without some serious politicking).  In fact, if the apple-loving visitors come with too big an appetite, a wasteful one perhaps, the smallest family member with the most growth potential may go hungry.  That's crowding out.

Crowding out also occurs when the actors are private sector businesses with the potential to grow and add jobs through the reinvestment of retained earnings and with the assistance of outside capital.  These businesses aren't usually concerned with apples, but care dearly about the factors of production, whether these factors are physical or monetary.  Physical factors include labor, equipment, and real estate.  Monetary factors include public and private debt and equity capital.

Like apples, there is a limited supply of tractors, dump trucks, computer techs, engineers, appraisers, land, and financial capital; and when a large new player comes into the market and pays up for various factors of production, other players lose access to those critical factors and disappear.  This loss of access happens at the margin, making a tractor or a mortgage loan one dollar too expensive for some businesses.  This loss of entities can be good if the new entrant is more efficient, has an improved product and prospects, and, as a result, creates more and better jobs. 

The question is, if the entrant is government, is that entrant more efficient with an improved product and does that entrant create more and better jobs?  Traditionally, the post office and DMV sufficiently answered this question.  However, in a more recent confirmation of ineptitude, President Obama persuasively demonstrated the consistency of government skill and efficiency by budgeting billions for non-existent "shovel ready" opportunities.

Crowding out is well documented.  A recent Harvard study focused on the effect of increases in government spending, as the result of the promotion of a district's congressman to a key spending position.  The study found that, after significant government dollars are spent in a state, the state's average private firm:

... cuts back capital expenditures by roughly 15%. These firms also significantly reduce R&D expenditures and increase payouts to their investors. The magnitude of this private sector response is nontrivial....also find some evidence that firms scale back their employment, and experience a decline in sales growth.

The study identifies a mechanism "by which government spending deters corporate investment" and provides "evidence that crowding out occurs through factors of production including the labor market and fixed industrial assets.

Similarly well known is the negative effect government borrowing has on private sector capital markets.  Even Secretary Geithner acknowledged this reality when he voiced concern that government borrowing would

 ... crowd out private investment.  With so much capital being required to finance government debt, interest rates are likely to increase for other types of borrowing.  Higher borrowing costs for American households and businesses will discourage future private investment, lowering our capital stock, reducing our economic growth and depressing our standard of living.

That is precisely what happened over the last two years, with big banks investing unusually large amounts in US treasuries, instead of making riskier commercial loans or lending to smaller banks who are the primary source of small business loans. 

Stanford's Ronald McKinnon recently explained that in 2011:

 ... the supply of ordinary bank credit to firms and households continues to fall ... If the prevailing interbank lending rate is close to zero (as it is now), then large banks with surplus reserves become loath to part with them for a derisory yield.  And smaller banks, which collectively are the biggest lenders to [small and medium size enterprises], cannot easily bid for funds ... without inadvertently signaling that they might be in trouble.

So crowding out occurs even in today's low rate environment.  The scales balance, regardless of the absolute level of nominal rates.  If the US government soaked up less of our savings, interest rates would be materially lower, particularly given that zero is no lower bound for real rates (real rate + inflation = nominal rate).

The greater the government borrowing, the greater is the crowding out.  Alan Greenspan echoed this when he commented that "a third of the decline in capital investment ... is directly attributable to the crowding out by the U.S. Treasury."    

US government spending and borrowing has thus crowded out small business expansion which, with stifling regulations, has sustained high unemployment.  Additionally, any new government jobs will typically have the job satisfaction, responsibility, advancement, and equity ownership of post office positions.  So we get fewer jobs and worse jobs (unless "shovel ready," in which case we get no jobs).

Despite the science of crowding out, there remain deniers -- a minority of economists and an entire political party -- who promote the fiction of a positive multiplier effect.  This mistaken group aggressively pushes the idea that government spending can produce an effect larger than the amount spent. 

A positive multiplier not only assumes away proven crowding out, it presumes private activity actually grows as a result of government spending.  It thus divines that the number of tractors, techs, engineers, and investment dollars is infinite, so that the government's entry into those markets causes no price appreciation or scarcity.  That's just not so.

A positive multiplier on government spending has been discredited by numerous reputable economists, who have demonstrated that increased government outlays substantially reduce private GDP.  A dollar of government spending is destructive and produces less than a dollar of net economic benefit.  Through spending, government destroys value and good jobs.  This is the point John Boehner made at the Economic Club of New York. 

Government must withdraw from the value destruction business and make the physical and monetary factors of production maximally available to the private sector.  The right size stimulus is at most zero, but ideally negative in the form of spending cuts and debt reduction.  Crowding out is why.