What is crowding out effect? How does it affect economies?

Summary 

  • The crowding out effect is an economic theory that defines a situation where increased government spending reduces private spending.
  • It discourages private businesses from raising capital via debt and making capital investments, bringing down total investment happening in an economy.
  • It results in traditionally profitable projects, being funded through loans, becoming cost-prohibitive.

Have you ever heard about the ‘crowding out effect? Well, if you have not, continue reading.

The crowding out effect is an economic theory that defines a situation where increased government spending reduces private spending. To increase its spending, the government borrows more from the market, leading to an environment of higher interest rates.

It happens when governments adopt an expansionary fiscal policy to boost the slowing economy. Generally, the initial rise in public spending is funded through higher taxes or borrowing on governments’ part.

It discourages private businesses from raising capital via debt and making capital investments, bringing down the total investments happening in an economy. The companies, which used to fund their projects through financing, take a back seat in such a scenario since the opportunity cost of raising money surges.

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It results in traditionally profitable projects, being funded through loans, becoming cost-prohibitive.

What are the different types of the crowding out effects?

Economies

The benefits ushered in via government borrowing are partially offset by cutting down on capital spending. However, it only happens when an economy is operating at capacity. Thus, the economic stimulus by a government is considered more effective when the economy is operating below its capacity.

In case of such an event, the government is forced to borrow even more as tax collections are reduced due to the economy’s slowdown.

Social welfare

Social welfare can also be an indirect reason for crowding out. In case governments raise taxes to expand their welfare programs, discretionary income with individuals and businesses gets reduced, leading to a cutdown in charitable contributions. Thus, reduced private spending on social welfare can offset the public spending on these causes.

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Infrastructure

The increased funding by the government on infrastructure development projects can make the sector less desirable or even profitable for the private sector to venture. You could see fewer private firms getting engaged in infrastructure projects such as toll roads or bridge construction in such a situation.

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Crowding out vs Crowding in

Meanwhile, there is another phenomenon just opposite to crowding out.  According to macroeconomic theories such as Chartalism and Post-Keynesian, the government borrowing can positively impact an economy operating significantly below its capacity. Increased government borrowing can result in increased employment, which may ultimately lead to a rise in private spending.  This economic scenario is known as ‘crowding in.’

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There are a few examples that support these macroeconomic theories.  During the Great Recession of 2007–2009, increased spending by any federal government on bonds and other securities resulted in bring down the interest rates.

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