What Is “Crowding Out”?

J.W. Mason has a nice article What Does Crowding Out Even Mean? on his site The Slackwire. I agree with some aspects of it not all.

Let me offer a slightly different (but similar) perspective. First the definition. When an economist—typically a new consensus economist—uses the phrase “crowding out”, he/she means that if government expenditure rises, private expenditure falls without output rising.

That’s it: rising government expenditure will lead to a fall in private expenditure with no positive effect on output according to this. And since new consensus economists also talk of government expenditures as less efficient, it also means that they are saying that real output will fall – a proposition that follows.

But this is a highly unlikely scenario.

There are various mechanisms that are claimed by the new consensus economists which will lead to this. The most basic mechanism is based on the assumption of an exogenous stock of money which is incorrect. There are other mechanisms highlighted: such as the central bank raising interest rates following a rise in demand.

Now suppose there is a rise in government expenditure leading to a rise in output and it follows with a central bank rate increase. Private expenditure will be affected, although this effect is not as strong as economists claim. But I won’t call this crowding out. Private expenditure may fall but compared to the counterfactual of no rate increase. Private expenditure in the future is likely to be higher than in present. So it’s not crowding out. Also output has risen in this scenario.

Also new consensus economists’ description around such issue is that the central bank’s interest rate rises endogenously but in reality it is in control of the authorities and it’s not as if interest rates rise naturally as the new consensus economists make it look.

In reality, there is only one extreme case where I can see crowding out happening in my definition. Suppose the economy is running under full capacity and the government raises its expenditures without changing the tax rate. Imagine the government is interested in some construction and does this via an auction to constructors. Since by assumption, the economy is under full capacity, a constructor working for the government means its project for a private firm needs to be postponed. So a rise in government expenditure has led to a fall in private expenditure with no effect on output.

But the above scenario is rather extreme and is unlikely to happen in most economies.

But, interest rates hikes in the US economy to say 5% in one year because of the Federal Reserve raising the short term rates in response to rising demand and output, whether justified or not, is not really crowding out.

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