Crowding Out – Huh?
from Peter Radford
One of the enduring myths spread about by opponents of debt financed stimulus is that every dollar borrowed by the government represents one less available for private business. This is called the crowding out of the private sector. Worse, so the story goes, since the government tends to spend its money of things that earn low returns, ostensibly, and because private business tends to spend on projects earning higher returns, this crowding out inevitably lowers the long run rate of return in the economy as a whole. We are thus impoverished.
The story was well told by a certain Samuel Doering of Minneapolis, US, in a letter to the Financial Times today. He was responding to an aspect of an article the FT carried by Larry Summers. Now you will all know by now that Summers is not a favorite of mine complicit as he was in the ill advised deregulation of banking in the Clinton years. Indeed his recent contrition has done little to rehabilitate him in my eyes – the mistake reverberates loudly. Nonetheless his argument that the US government should borrow at today’s low interest rates and invest in infrastructure projects as a way of stimulating the economy makes sense to me. Good for him.
Mr. Doering sees things a little differently.
Somehow he thinks Summers is arguing that the government is well suited to allocate capital within the economy on a more permanent basis. While some people may be arguing that I am not sure Summers is. The gist of Doering’s argument is that we ought not measure the success of government investment by its positive or negative nature, but rather by using the measure known as the return on capital [ROC], which is the profit made on an investment. He extends his argument by pointing out that the market for capital rarely, if ever, would allocate capital to the kind of low ROC projects the government usually invests in, but would prefer the higher ROC provided by private business. And here we arrive at the crowding out argument: by raising capital and investing it those low ROC projects the kind of government action called for by Summers necessarily reduces our economic potential.
In Mr. Doerings own words:
“The more the government removes dollars from the private sector and employs the funds at an efficiency rate below what is available elsewhere, we only succeed in stunting our economic growth.”
Where do we start?
First: the presumption seems to be that were it not for government borrowing crowding out the private sector would be happily borrowing and investing. Presumably at high rates of return. Things would be jolly. This is nonsense. The private sector is doing its best to avoid borrowing. Indeed it is well documented that we are in the midst of a large scale reduction of debt across the private sector. The banks are awash with funds to lend. Borrowers are few and far between. Not only this, but the private sector is itself awash with cash. It prefers to earn minimal or worse, less than zero, on this cash than invest it in projects. Presumably, and unfortunately for Mr. Doering’s argument, this is because the ROC available in today’s economy is even lower. Why invest if you can’t earn a profit?
Second: the presumption that all government projects produce a low ROC is open to challenge. This is for two reasons. One is that our national accounting doesn’t produce the kind of numbers we need to evaluate a government project from an ROC perspective. The national accounts don’t differentiate properly between government capital spending and its consumption spending. It appears intuitive to suggest government ROC’s are low. But the evidence is absent. The second is a more telling counter argument: ROC is not a good metric under any circumstance. It excludes the riskiness of the return. To rank our investments in a more disciplined way we need to use something called a Risk Adjusted Return on Capital [RAROC]. This would, I suggest, cause a different result. If we accept that government projects tend to produce low returns – building sewer systems is hardly go-go stuff – they are also very low risk. So the return on government projects is not as wealth destroying as Mr. Doering is trying to make it appear. To put this in perspective: the private sector poured hundreds of billions into real estate a decade ago. The ROC looked good. The RAROC was appalling. The inherent risk destroyed, utterly, the return. So by using the wrong, by virtue of being too simple, metric the private sector misallocated a huge chunk of out national wealth. Destroying swathes of it in the process.
So there are two simple and significant errors in Mr. Doering’s argument.
There is no crowding out because the private sector doesn’t want to borrow. Thus there is no competition for funds between the private and public sectors. And, second, it is by no means clear that the private sector produces, consistently, a higher RAROC. Or rather, it is not inevitable that just because the ROC on private projects is usually higher than that of public projects the economy’s long run wealth is diminished by government investment.
Besides the present lull in private sector investment is one of the biggest reasons our economy is in depression. It makes sense too. Business won’t invest because it cannot foresee a profit on that investment. Its called a lack of demand. One way to rebuild demand is for the government to invest.
Which is what Summers was arguing for, and which is what Mr. Doering and his ilk are arguing against.
It’s really not complicated. Is it?