The phrase “crowding out” in economics refers to a situation where government spending (which is part of fiscal policy) discourages (private) investment spending in the economy. This is considered a bad thing, since investment spending is one of the key drivers of economic growth.

Let’s briefly examine crowding out in the context of the aggregate demand component of the aggregate demand–aggregate supply (AD-AS model) of the economy. Aggregate demand is, put simply, the summation of demand in the economy, and when it increases it encourages economic growth. The formula for aggregate demand is AD = C + I + G + NX.

In this formula, C is consumption spending by individuals and firms, I is investment spending, G is government spending, and NX is net exports. If any one of these components changes, ceteris paribus, the AD curve will shift. For more on aggregate demand and its components, read the linked article.

Students familiar with this concept may be confused by crowding out at first. G in the above formula is related positively to aggregate demand. In other words, when G increases, it should increase AD, too. And since AD can be thought of as overall demand in the economy, increasing AD should encourage economic growth, and thus be a good thing. How, then, does crowding out work? How could increased government spending be a bad thing for the economy?

The mechanics of crowding out

There are two main ways that increased government spending can reduce, or “crowd-out”, private and investment spending. These take place when the government either raises taxes or takes on debt to pay for increased government spending G.

In the former case, raising taxes reduces C and I by some amount that may or may not be larger than the increase in government spending G, because when consumers and firms pay higher taxes, they have less money of their own to spend. In other words, if increasing G means that C or I must decrease, it’s mathematically clear that the increase in G might be completely offset by reductions in C or I. This would lower AD and depress the economy. Without more specifics, we can’t say for certain if aggregate demand increases or decreases overall.

One prominent theory among economists is that when the economy is depressed or in recession, it’s performing below its potential, so an increase in government spending increases G more than it reduces C or I. This increases AD; thus, increased government spending is good in times of recession. This is the view taken in particular by many Keynesian economists. Further, in these times households and businesses typically have a lower marginal propensity to consume, instead choosing to save more. So, government spending funded by taxes can help shift the balance of income towards more consumption spending, boosting the economy (in the Keynesian view, at least).

The second way that crowding out can work is as follows. When the government borrows money, it affects interest rates through the loanable funds market, depressing investment spending and encouraging saving. In short: increasing government debt increases the interest rate, which makes it more expensive for everyone else to borrow, disincentivizing firms from making economy-growing investments. This “crowding out” of firms’ investment is either net-neutral or negative for the economy’s growth.

To see how government debt increases the interest rate, consider the following. When the government takes out debt, it is essentially acting as a large consumer in the market for loanable funds. Thus, the demand for loanable funds increases; and what happens when demand increases for a specific product or service? The price increases, too, to maintain equilibrium. 

In this case, the price of borrowing funds is the interest rate. So, increasing government debt drives up the interest rate and therefore disincentivizes firms from making costly but economy-growing investment spending. Over the long term, this can reduce the economy’s competitiveness in a global market, slow down the pace of innovation, and ultimately reduce the economy’s long-term growth potential.

In summary, then: crowding out can occur when increased government spending G is funded by higher taxes (which reduces the amount of money that individuals and firms have to spend), or by increased government debt (which increases the interest rate, reducing investment spending by individuals and firms in the economy).

Further details on how crowding out works

As an aside, astute readers may wonder how government spending changes interest rates when the central bank exists. After all, doesn’t the central bank set interest rates? The article monetary policy dives into this further; essentially, the central bank is (normally) a separate entity from the federal government and is (in most cases) not beholden to political whims. It sets an interest rate target and uses monetary policy to achieve that goal.

But the federal government may have its own aims with its fiscal policy, and so may choose to increase spending – possibly putting upward pressure on the interest rate regardless of the central bank’s policy. Conversely, it’s also possible for fiscal and monetary policy work in tandem if the central bank and federal government share the same goal, like helping the economy recover from a recession.

It may be unclear to some readers why exactly an increased interest rate discourages investment spending. Recall that the interest rate represents the cost of borrowing money. At a low interest rate, it’s cheaper to take out loans that can be used to pay for big, important purchases like a house, an advanced degree, or building a factory.

Typically, when making investments into growing the business, a firm needs to raise a lot of money – and borrowing money is a common tactic to do so (and an important function that banks provide to the economy). So, at a lower interest rate, borrowing is cheaper and many such investment projects would be profitable, growing the economy. But, a higher interest rate means that more investment projects become too expensive to be worth it, so fewer firms will borrow money to build new factories (for example). Thus the economy grows more slowly than if interest rates had been lower.

In summary then: crowding out can occur if increased government debt drives up the interest rate even despite the central bank’s monetary policy goals, thereby reducing investment spending in the economy by other actors.

Crowding out in economic thought and modern political discourse

Classical economists believe that markets are always efficient, guided by Adam Smith’s invisible hand. Because of this, they believe that government spending is at best net-neutral in the economy, and often has a net-negative effect on economic growth. Thus, classical economists often support a minimalist fiscal policy.

This reasoning follows from the above discussion, but it goes further. Government spending must be funded either by taxes taken from consumers and firms, or from government debt. Both of these actions, in the classical view, ultimately harm the economy.

In the former case, individuals and firms are made worse off because they must pay higher taxes, so they cut back on spending – this reduces economic activity. We’ve already discussed the interest rate implications of increased government debt.

But classical theory provides another reason why this debt might hurt the economy. In the classical view, this debt can cause consumers and firms to cut back on spending because they need to save for increased future tax expenses. This is because consumers and firms expect that the government will raise taxes in the future to pay off their debt, so firms and consumers decide to reduce their spending and save more instead. This eliminates any positive benefit that increased government spending may have had.

Crowding out in modern discourse

Although classical ideas have come in and out of style over the course of history, they remain influential in economic discourse. In fact, in the modern age, many centrist or right-leaning politicians tend to disapprove of government spending, because they believe it crowds out private sector spending and investment – even if they don’t use the term directly – and that this will ultimately harm the economy.

In this way, they tend to agree with the classical economists. The line of reasoning is thus: government spending must be funded by higher taxes, which discourages consumer and investment spending, and slows down the economy.

And of course, this article hasn’t yet touched on how the government spends its money! If the government is wasteful, or spends its money on goods or services that do not improve the economy (think of wasteful luxury spending for government officials), then negative effects on the economy are more likely. Essentially, the funds the government borrowed are not used for productive purposes in such a case, but they could still increase the interest rate and risk crowding out private investment.

This is another idea that many modern political commentators may use to argue that government spending is wasteful. Students of economics can likely find plenty of examples of arguments against crowding out (and conversely, arguments for government spending) in the news today.

Good to Know

Curious readers may ask: who does the government borrow money from? The answer may not be initially obvious, since governments don’t go to the bank to borrow money like most other firms and consumers do.

One of the major ways that governments borrow money is by issuing financial securities such as bonds. A bond is a financial asset that anyone can purchase. When a consumer or firm buys a government bond, they pay the government money for the asset. Each bond has a maturity date and an interest rate attached to it, and represents a promise of repayment later.

For example, let’s say that the French government wants to raise money, so they issue bonds to do so. French investors buy all of the bonds. The sum total of all the money the French government sold the bonds for is essentially the amount of a loan that the French government has taken out. Instead of a bank, the loan issuer in this case is the French population. The interest rate on the bonds issued is the interest rate that the French government must pay back to the public upon reaching the maturity date when the debt payment is due. Of course, in the modern age banks and investment funds tend to buy bonds in great quantities as well, not just individuals.

Note that individuals or institutions outside of France could have potentially bought some of the French bonds too, meaning that France would owe some money to foreign entities as well. This is one of the ways you may hear about governments owing money to other countries in the news.