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Crowding Out

There are three different ways that a national government can fund its spending, and the way it chooses affects the macroeconomic effects of that spending. Pretty much everyone agrees that if a government funds additional spending with taxes, the macroeconomic effects are small. The tax increase cancels out any multiplier effect of the spending, so its overall effect is negligible.1

Also, everyone pretty much agrees that if a government funds additional spending by printing money, the effect on total spending will be large. No one's spending is canceled out in this case, and both monetary and fiscal policy are working together.

The controversial case has always been the case in which government borrows to fund additional spending. A central question in the dispute is how well do financial markets transfer funds from those who do not want to spend to those who do. The original Keynesian position was that these markets do not work at all, so they can be ignored. This was rather quickly amended with the ISLM model, in which financial markets could work. Now when government borrowed, it would increase interest rates (because there was an increased demand for loanable funds, driving up their price), and the higher interest rates would reduce some private borrowing. In other words, increased government spending would crowd out some private borrowing. If the amount crowded out was small, then fiscal policy would still work pretty well. If the amount crowded out was substantial, then the effects of fiscal policy on total spending would be largely eliminated. For many years there was active debate on this issue, and it remains unclear how important this crowding out effect is.

In the past few decades another avenue of crowding out has become apparent, one involving the international flow of funds. As the world financial markets have become more integrated, money will flow in response to differentials in interest rates. If the rate of interest in the U.S is 5%, and the rate of interest in England is 10%, there is a tendency for people to invest in England rather than the U.S. However, there is a danger for an American investing in England because the American must go through the foreign exchange market twice, and if the price in that market changes, any advantage of getting the higher rate of interest can be lost. Problems tend to generate solutions, and in this case the solution is the futures market. Using these markets, one can lock in the prices of future transactions, which eliminates all risk from exchange rate changes.

In this integrated financial world, what will happen if the U.S. government decides to spend more and finance that spending by borrowing? The extra borrowing will tend to nudge up interest rates in the U.S. relative to the rest of the world. This will tend to draw foreign savings into the U.S. financial market. This increased demand for U.S. dollars will tend to raise the price of the dollar relative to the value of other currencies, thus making American goods more expensive abroad and foreign goods less expensive in the United States. Hence, net exports will drop, which will offset part of the macroeconomic effects of the increased government spending. This is another, and perhaps the most important, avenue of crowding out.

For fiscal policy to be effective as a tool of macroeconomic policy, it must not crowded out other spending.2 It also must have a substantial and reliable multiplier. The multiplier depends on people reliably spending additional income. The development of more sophisticated consumption functions in the 1950s, such as the life-cycle hypothesis and especially the permanent-income hypothesis, eroded belief that the multiplier is as reliable as the original Keynesian models suggested it was. The end result is that size of the Keynesian multiplier remains a subject of dispute in economics.

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1The old textbooks delighted in explaining why the balanced-budget multiplier was one. The extra government spending was counted in GDP, but it induced no additional consumption spending because its effects on consumer income were offset by the tax hike. However, this reasoning is only valid in simplistic models. In more complex models, the balanced budget multiplier can be less than one.

2Do you need more? Here is a fifth problem with fiscal policy, though its importance is unclear.

People tend to be more productive in stable environments. For example, would baseball teams play better ball if the strike zone changed every inning, or if the strike zone is consistent? The time and effort players spent trying to figure out what the rules were for the inning would probably detract from the quality of play. The same holds for the economic game; people play better in a stable economic environment.

There are a number of factors that contribute to a stable economic environment. Perhaps the most important is what is called "the rule of law." The expression means that laws are clearly spelled out and impartially applied. Without a rule of law, people cannot make accurate cost-benefit decisions that are necessary for economic growth and prosperity. One of the major obstacles to economic development in the former Soviet Union is that the tradition of a rule of law is weak.

Constant prices also contribute to a stable economic environment. Inflation disrupts that environment, making economic decisions more difficult. Finally, if tax rules are in constant flux, or if the government spending programs are changed too often, the economic environment is less stable and hence less conducive to economic prosperity. An active, discretionary fiscal policy will cause tax and government expenditure rules to change often. Although this cost of fiscal policy may not be very large, it does exist and will be greater the more use a government makes of discretionary fiscal policy.

Copyright Robert Schenk