Home > The Economy, Uncategorized > Crowding Out – Huh?

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.”

Oh dear.

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?

  1. Ignacio
    July 4, 2012 at 3:25 pm

    I would add that the crowding out crowd are stared by the ROC obtained in a bunch of private instances that are really profitable, but they tend to ignore the more numerous instances in which private investments are not profitable. You cannot compare the ROC of Google with that of government investments.

  2. robert r locke
    July 4, 2012 at 3:32 pm

    No it isn’t complicated, but what can one do when argument faces conviction. So much of economics isn’t argument but conviction, beliefs. Mr Dorring is not investigating a problem but confirming a conviction.

  3. July 4, 2012 at 6:01 pm

    When the rotting infrastructure falls through, and roads, schools, hospitals, police, firefighters, social services etc. can no longer be counted upon, what will the ROC be for the private sector? Why is Return on Capital more important than the necessities of life?

    I’d love to exile those who think this way to a barren island. Let them take a huge pile of thousand dollar bills with them. They can burrow into it to stay warm at night.

    • July 9, 2012 at 9:05 am

      Ha! That reminds me of an article I wrote for Op Ed News a few years ago in which I promised to:
      “…personally pay for a one-way flight to anywhere in the world for anyone who made at least $100 million in the financial industry last year – first come, first serve – IF they will will sign an agreement promising never to return to America, or to work for an American headquartered company, ever again. I will even pay First Class, because you know, such Titans can’t be expected to fly in a manner they aren’t accustomed to.
      Since I can’t put these people in prison, I’ll settle for banishment.”
      My argument is that we are ultimately better off without these people.

      As far as the crowding out argument goes, it is pure nonsense. It assumes a static universe where the number of things to be done is finite and the productive capacity of the nation is already close to being fully tapped. In reality, neither is true. If it were, we would have “run out” of jobs long ago. Why didn’t we run out of jobs when the population was half what it is today, when we were in the Stone Age, or when Homo Sapiens numbered only 50,000 original people in the world?
      No, the truth is there are always and everywhere, millions of jobs to be done, and millions of people who want to do them. The only thing standing in the way is MONEY (and our outdated notions of what money is).
      Real wealth is produced by labor, acting upon the natural resources of the world (or at least producing mental labor) to make the things that satisfy human desires and which have exchange value (so your hard-gained collection of bottle caps may or may not qualify).
      We know where the money is and we know those same people now control the creation of money – the Central Bank’s “independence” notwithstanding.

      Oh, and one final small correction to the article. The ROC for companies may be high if they simply “invest” in their own company stock at today’s ultra-low rates. Big companies are doing this all over the place, but this benefits the C-suite with their pay in holdings of options and stock, not the customers, nor society at large.

  4. Podargus
    July 4, 2012 at 8:10 pm

    The US government,being sovereign in its own currency,has no need to borrow its own currency.The present arrangements are just a fiction to maintain some silly ideological (aka religious) notion held by the current crop of the conventionally “wise”.

  5. Ken Zimmerman
    July 4, 2012 at 11:31 pm

    I agree with the article and all the comments thus far. And to add one consideration, I defy any private enterprise to make building a sewer system, or a city general service hospital, or a public health clinic, or a DMV service center, or a bridge over the Ohio River, or a senior center, or a public park, or a police dept., or a city school system, etc. a highly profitable investment. In fact, many of these lose money on a regular basis. Now that can be changed by shifting dollars from building and personnel to paying returns to investors, by gold platting the school, bridge, etc. (as least on paper) and sending the money thus siphoned off to investors, or by providing as few real services as possible and sending the money not used for services to investors. There simply is no other way to make such projects highly profitable from a private business perspective. So which choice appeals to people the most? I think this is part of what the current Presidential election in the US is about.

  6. July 5, 2012 at 3:27 am

    On the crowding out issue, conventional theory posits both domestic and internatioal crowding out from Keynesian stimuli that generate significant deficits and debt. One mechanism is increased government borrowin and spending crowding out private investment two ways: draining absolute amount of funds available for all investment public and private and bumping up interest rates choking off private investment (assuming there was any reason to borrow to invest even at lower interest rates–ceteris paribus fallacy common here as there are many variables governing investment and not only one interest rate); then on the internaitonal side, supposedly internatonal crowding out via higher prices choking off net exports and putting downward pressure on the dollar; higher prices putting upward pressure on nominal interest rates to retain given real interest rate targets of lenders, choking off investment plus putting upward pressure on the dollar from increased inflows of dollar-denominated investment demanding dollars and with higher exchange rates on the dollar choking off net exports long run… These are some of the supposed mechanisms of the twin deficits–federal budget and trade.

    But all of this assumes that a lot more than interest rates affect investment or willingness to borrow to invest in the economic sense of spending on productive capacity rather than 3- second trades and pure spectulation. There are so many fallacies emodied in all this kind of linear, undirectional chains of causality that neoclassical and even Keynesian theory love and push so much. In the real world of multiple causality, effects, positive and negative feedback, morphogenetic rather than morphostatic systems, it is just more of the same and the same ways and approaches yield the same results only worse as one cannot step twice into the same river of history.

  7. Alice
    July 5, 2012 at 11:23 am

    I think the thing we all overlook is that a main reason the stories ever got invented about “crowding out” killing private sector investment is simply because some (probably the 1%) wanted lower taxes (which they got in big doses) and in order to get lower taxes (for some) you have to squeeze the government not to spend…then invent fairy stories why Governments shouldnt spend eg “crowding out”..

    Whats worse is that some obviously buy that idea wholesale.

    But its too late now. Governments got squeezed, lost the skills to manage large infrastructure projects, sold the materials they once held in stockpile for such and now just manage primarily their media appearances, salary increases, trips, re election campaigns, post retirement appointments, hairstyles, dress codes etc.

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