...against fictions and other tall tales

Wednesday, 14 March 2012

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

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.


  1. Great post. I was hoping that you would stress the fact that bank lending, whether to households, businesses or government, creates deposits. If new deposits are created with new loans, how do you crowd out deposits.

    The common sense experience that we have with banks is that we are told that they lend out deposits (which is true from a certain point of view). But nobody can identify a time when they could not spend their deposits because they were already lent out.

    Bank loans are not like loans from my parents to their child. If the parents lend money to their children, they are effectively giving their deposits away for a period of time. The child will repay that debt by sending money back to his/her parents.

    Market based system does not function this way. I can lend money to a corporation, but I get a corporate bond in return. The corporation can spend my money, but I can sell the corporate bond. So, in a sense, I can spend the bond. Bank liabilities, ie deposits, are money-good assets, but so are corporate bonds, which can be sold and subsequently spent.

    As usual, circuit that was a great post. I noticed that the Bernier, the French-Canadian Austrian, is up to his old tricks.

  2. Excellent post. Too bad juo missed the Cavanaugh, and A&A references. On the other hand, since Mr. Bernier is a junior! Minister, one should overlook his staffers' exclusive arguments and similar 'rubbish'. However, as a general rule of thumb for politicians, freshmen pundits and analysts-crowding out/crowding-have ambivalent precedents and settings in both developed and 'developing economies.' Although circuit !! makes an excellent case for the non-crowding effect of PX. Another rule of thumb: Tax-financed public expenditures (PX) crowd out more than debt-financed PX although that scenario usually indicates liquidity issues within the economy. Just to add a couple of old-timers: Barro, Tulloch and Easterly among the many excellent economists conclude with divided opinions.Finally, as swells has insinuated although he targeted one sector specifically, GDP growth will also depend on whether PX is productive and unproductive.

    Nice touches circuit

    1. I appreciate your comment but why do you refer to Barro as an old-timer

    2. lol. nice rebuff. I wasn't referring to his age but the excellent vintage of Bob Barro's article 1990 (22 years ago) Barro, Robert J: Government Spending in a Simple Model of Endogenous Growth.

    3. Now that's daring Goffredo! I like the touch of using a gem from an anti-stimulus economist to find stimuli operatives. Better than what some pro-stimulus popular economic columnists do when they rate Barro as 'boneheaded'. At least Barro seeks to implant empirical legitimacy in his work; much more than what the deans of 'pop economics' can do. It's great to see someone commend opportunities in a border-line sympathizer like Barro; it's better than reading 'dump-jobs' on the man.

      In fact, one wonders if any of these same pamphleteers ever read the macroprudentials by BIS's Borio and White years ahead of their time or the insights of '70s Fed alchemists, before commenting on the existing crises and its settings, and pontificating on the operations of the monetary system and Keynesian benefits and parameters. From their references, if they have any, it doesn't look like they're up on good reading, if any reading at all, besides their own fan-club.

      Now FRB cites Borio!...If there's an alternative economic process being articulated for policy, then the most interesting efforts to synthesize the mayhem is in this column. I look forward to the next feature. It's difficult but there's great work out there in the macro-diversity of contemporary economics.

  3. Un vraiment bon posting, circuit. A+

  4. Anon, thanks for the added insight. Now that you brought it up, I should emphasize that what you are describing is fundamental for understanding the true nature of government deficits. As you mention, government in no way restricts the amount of funds that can be lent to the private sector. This is well put: "If new deposits are created with new loans, how do you crowd out deposits?".

    Goffredo and Coleen: As always, I appreciate your comments. Goffredo, thank you for sharing these two "rules of thumb". This is exactly the type of policy advice I wish to highlight on this site. Very nice addition to this post.

    I should say that one precision that is missing from this post (but that I intend to discuss more fully in later entry) is the notion that crowding out should not be regarded as the result of government borrowing, but rather of government *spending*. An important nuance. Arguably, government can "crowd out", that is, take resources away from the private sector, in a context of a government surplus. For this reason, that's why I think it is incorrect to associate crowding out solely with government deficits. It's the spending that "crowds out", not the borrowing. This also ties into Anon's comment above.

  5. Nice post, circuit. Doesn't the US look like the perfect acid test for crowding-out/crowding-in. Haven't heard one Austrian complain and one corporate complain. The former are dumb-bound and the latter love it. Keep up the solid insights.

    1. Thanks Swells. Of course, the corporates appreciate the crowding in of profits. The third part of my series on deficit myths explains the positive effect of government deficits on profitability. The US is definitely the place to be analyzing the crowding in effects, especially now that many other advanced economies are now veering towards austerity.

    2. Absolutely. If you're a cynic about government spending, the US is proof that at least there are silver linings coming through. Even Cameron asnd Osborne have decided to review their infrastructure budgets. Excellent work FRB.

    3. Thanks DESHarSG. Great comments. Glad you enjoy the site. As for Borio, White et al, I agree with you. There's some good work stemming from the BIS. Obviously, I disagree with Krugman's across-the-board assessment of the BIS as a bastion of policy orthodoxy (see his Oct 25, 2011 post).

  6. DESHarSG wrote: Don't get me wrong. People in general do excellent work; but they also have a tendency to get personal and then it gets sloppy. Keep FRB above the 'nonsense' as one of your readers suggested. I liked your piece on Crescenzi's inconsistency and JL's on FPvsMP. Re latter although political pragmatism requires the distinction, fiscal is for all intents and purposes, an ancilla of MP.

    DESHarSG: Sorry DESHar, I accidentally deleted your comment while to trying to respond. I am re-publishing your comment.

    BTW, thanks very much for your support. Greatly appreciated. Feel free to share your thoughts and insight. Best, circuit