Deficit myths (Part 4): A note on crowding out

Maxime Bernier, Canada's federal Minister of State for Small Business and Tourism, wants us to believe that Keynesian policy remedies that aim to increase government spending in the economy have zero effect on aggregate demand.  According to Bernier, every time the government borrows funds from the private sector, the private lenders who lend to the government will have less money to spend or invest elsewhere, or will have less money to lend to other businesses.  Bernier sums up his thoughts as follows:

Government borrowing and spending goes up; private borrowing and spending goes down.  There is no net effect, no increase in overall demand.  It's like taking a bucket of water in the deep end of a swimming pool and emptying it in the shallow end.

In other words, according to Bernier, deficit spending by the government "always and everywhere" (to use Prof. Friedman's words) crowds out private sector spending and investment.

Here's the thing: this is like saying that government deficits fully crowd out private spending all the time, a completely untenable proposition.  The problem with this notion of "100 percent crowding out" is that it defies common sense and is not supported by the facts.  I have always found that the problem with this view of crowding out was best described by Francis Cavanaugh, a long-time career economist and executive with the US Treasury, in his book entitled The Truth about the National Debt.  According to Cavanaugh,

If we were to accept the argument that government deficits crowd out private investment, then we might accept the argument that government surpluses "crowd in" private investment.  By that logic, a tax increase resulting in a surplus would lead to an increase in private investment. The government takes more money from the private sector, and somehow the private sector has more money to save or invest. Nonsense. (p. 45)

Another problem with Bernier's claim that deficit spending by the government fully crowds out private investment is it implies that cuts to government spending must result in an offsetting increase in private sector spending.  That's like saying that public sector austerity leads to greater private sector spending.  However, as many economists would argue, the evidence to support this claim is very weak.

In fact, one of the most influential papers (by Alberto Alesina and Sylvia Ardagna) on the benefits of public sector austerity and the notion of "expansionary fiscal consolidation" is now being criticized on important methodological grounds.  The economist and former Chair of the Council of Economic Advisers, Christina Romer, sums up the criticism as follows:

Unfortunately, there turns out to be a lot of omitted variable bias in Alesina and Ardagna’s empirical analysis.  Some of their fiscal consolidations weren’t deliberate attempts to get the deficit down at all.  Rather, they were times when the budget deficit fell because stock price booms were pushing up tax revenues.  Stock prices were a big omitted variable.  They were driving the deficit reduction and were likely correlated with rapid output growth.  This omitted variable made it look as though deficit reduction was expansionary, when it really wasn’t. (2011:18)

Finally, it should be emphasized that, in the case of Canada, Bernier's claim that government budget deficits inhibit private sector investment is not supported by the facts.  As you can see in the chart below showing the (consolidated) government fiscal position and the total level of business investment in structures, machinery and equipment as a percentage of GDP since 1981, there is no relationship between the fiscal position of the government sector and level of business investment (click on chart to expand).  Indeed, the level of business investment remained within a fairly constant range during the entire period, regardless of whether the government sector was running a deficit or not.

Source: Statistics Canada

References

Alesina, A and Ardagna, S., "Large Changes in Fiscal Policy: Taxes vs Spending", NBER Working Paper No. 15438, October 2009

Cavanaugh, F. X., The Truth about the National Debt (Boston: HBS Press, 1996)

Romer, C., "What do we know about the effects of fiscal policy: Separating evidence from ideology?", Hamilton College Speech, November 7, 2011.

The FRB blog invites your comments. Please share your thoughts below.