The crowding-out effect is an economic phenomenon where increased government spending, often funded by borrowing or taxation, can lead to reduced private sector investment and consumer spending. This can result in higher interest rates and hinder economic growth, impacting industries like resources, infrastructure, and healthcare.
Table of Contents
Breaking down the crowing out effect
The crowding-out effect describes the way government spending reduces private spending.
Public sector spending is accommodated by increasing taxes or the level of borrowing itself. This reduces available capital and decreases consumer confidence.
In the long term, the crowding-out effect inhibits economic growth and, in some cases, can exacerbate pre-existing fiscal issues.
Understanding the crowding-out effect
Governments engage in spending to increase demand for goods and services among consumers at a given time and price – otherwise known as aggregate demand.
However, such public spending is theorized to decrease aggregate demand instead of the reverse.
How governments finance this increased spending explains the crowding-out effect and how it can reduce consumer confidence in spending.
Spending is usually financed by:
Increasing tax – taxes imposed on consumers and businesses reduce the amount of discretionary income, thereby reducing demand for goods and services.
Increased borrowing – governments finance borrowing by selling bonds to the private sector through pension funds, investment portfolios, and private individuals. With private sector capital invested in government bonds, there is less to invest back into the private sector itself.
Fundamentally, the crowding-out effect reduces the total amount of savings available for investment. As public spending increases, so too does the demand for available capital.
However, the total amount of capital remains constant. This has the effect of increasing interest rates to a level where only governments can afford to service loan repayments.
When this occurs, individuals and businesses of all sizes are forced, or “crowded-out” of the market.
Consider the case of a company looking to borrow $100 million to build a new headquarters. Before government spending, the company was offered an interest rate of 6%.
But after the government announced it would offer business loans to stimulate the economy, the company finds the interest rate is now 8%.
With a 33% rise in the interest rate, the company cannot afford to service the loan.
They are in effect prohibited from entering the market, and the resultant jobs and consumer spending that would have occurred from construction are also lost.
Why does the crowding-out effect matter?
Decreases in private sector spending on goods and services ultimately slows economic growth.
When governments borrow money to stimulate consumer spending during a recession, consumers are fearful of being crowded out and subject to higher taxes or interest rates in the future.
As a result, they tend to save the stimulus money instead of spending it. This, in turn, renders fiscal stimulus packages ineffective.
The cyclical nature of the crowding-out effect
Government spending has the potential to backfire and reinforce the problem it was designed to address. This can be observed in the following examples:
Economy – governments that spend more to address shortfalls in tax revenue may create a negative cycle where they spend more and more capital to try to stimulate a private sector that becomes increasingly crowded-out of the market.
Welfare – with more consumers turning to welfare during a recession, the government must spend more money to accommodate them. This spending is derived from borrowed capital that is serviced by governmental raises in private sector interest rates and taxes. This then reduces discretionary income and makes consumers more reliant on welfare.
Crowding-out effect examples
Let’s conclude by explaining some typical instances where the effect may occur.
Resources
When governments purchase a sizeable percentage of the supply of a particular good, they make it difficult for private sector companies to meet their production schedules.
This tends to be common in wartime when the construction of military equipment and associated items is prioritized. Resources such as iron ore, copper, and steel are the most affected.
Governments that borrow money to fund extra production and subsequent military campaigns can also cause interest rates and inflation to rise in the domestic market.
Infrastructure
The effect can also be seen in market-based economies where both the public and private sectors are infrastructure providers.
To kickstart the economy after a protracted recession, suppose that a government wants to spend money on new railways, ports, and roads.
While infrastructure investment is an effective way to stimulate growth, it can discourage the private sector from providing similar services.
This is exacerbated by the fact that private firms have less access to the abundant capital the public sector can create for itself in times of economic need.
Consumer products
The recent shortage of commercial milk formula in the United States could also be due to the crowding-out effect.
The primary buyer of baby food (and indeed the largest in the country) is the government-run Women, Infants, and Children (WIC) program.
Some analysts believe that the WIC’s exclusive contracts with suppliers prevented smaller competitors from entering the market.
Ultimately, baby formula had to be sourced from as far away as Australia to make up for the shortfall.
Health insurance
In a healthcare context, increased expenditure on public healthcare by governments can crowd out private insurance providers.
As the quality, coverage, and attractiveness of the public system increases, consumers see less need to pay a premium for the private option.
This can also extend to the workplace where in response to rising prices, fewer businesses offer health insurance to employees as part of their salaries.
Somewhat paradoxically, this can cause the number of insured individuals to decrease despite the increase in government spending.
Venture capital
The crowding-out effect is also observable in the venture capital industry. When governments fund budget deficits by borrowing money, they compete with other borrowers in the economy over finite capital.
This causes interest rates to rise and venture capital investment to drop.
However, in some instances, investment in public capital raises the returns of private venture capital and causes it to increase.
This is known as crowding-in, an effect where higher government spending leads to an increase in economic growth.
Here, the increase encourages private firms to participate because of the presence of profitable investment opportunities.
Let’s further expand on the crowding-out effect example for the venture capital industry.
In a 2007 study, researchers Douglas J. Cumming and Jeffrey G. Macintosh wanted to know whether a Government of Canada initiative to fund new companies crowded out private VC companies in the country.
The public initiative was underpinned by a venture capital vehicle known as the Labour Sponsored Venture Capital Corporation (LSVCC).
Launched in the 1980s, the initiative was introduced to increase the total amount of venture capital in Canada.
It was also seen as a way to increase the number of entrepreneurial firms and enable the government to benefit from economic growth, innovation, and the creation of extra jobs.
To stimulate interest in the scheme, LSVCCs offered generous tax credits to those who invested. It was these tax credits – and their potential to crowd out private VC funds – that Cumming and Macintosh were particularly interested in.
Analyzing the data
The pair analyzed empirical data over the period between 1977 and 2001 and found that the Canadian Government initiative had the reverse effect.
In other words, instead of increasing the aggregate pool of venture capital in Canada, LSVCCs caused it to decrease.
Exacerbating the crowding-out effect was the fact that the government initiative was simply an inferior investment vehicle. This was due to several reasons:
Geographical constraints – LSVCCs were only permitted to invest in start-ups in the province in which they were founded (irrespective of market conditions and whether other markets offered a better rate of return).
Financial constraints – the size and nature of an LSVCC investment was also constrained. It was a requirement that a certain percentage of funds be invested within a period of 1 to 3 years. Once more, this constraint did not account for prevailing conditions in the market or economy, and
Competition – since governments predetermined how many LSVCCs would operate in each region, competition was stifled and there was thus no incentive for funds to offer higher rates of return.
Implications of the crowding-out effect in the VC industry
The study noted that the combination of geographical constraints and time-sensitive financial constraints caused LSVCC managers to make poor decisions under pressure.
This could lead to investments in businesses in detrimental market conditions, or worse still, investments in inferior businesses.
It was also acknowledged that since LSVCC managers contracted out investment management services to a third party, there was less incentive for them to perform.
This caused a distant relationship between the fund manager and investors that reduced the latter’s ability to offer incentives or discipline managers for subpar performance.
The inferiority of the LSVCC option also caused capital to be raised but not invested.
Since $3.8 billion remained on the table, fewer businesses were being created than if the funds were managed by private companies with more attractive terms and management.
In any case, these companies were unable to compete with the tax credits offered by the Canadian Government and the way such credits influenced acceptable rates of return.
In their concluding remarks, Cumming and Macintosh noted that LSVCCs crowded out approximately 400 private VC investments each year in Canada worth $1 billion.
Case Studies
Resources:
During wartime, governments may purchase a significant percentage of resources like iron ore, copper, and steel to prioritize military equipment production.
This can disrupt private sector production schedules and lead to resource shortages for other industries.
Infrastructure:
When a government invests heavily in infrastructure like new railways, ports, and roads, it can discourage private sector firms from providing similar services.
Private companies may have limited access to capital compared to the government, making it difficult to compete.
Consumer Products:
In the United States, the government-run Women, Infants, and Children (WIC) program is a major buyer of baby food.
Exclusive contracts with suppliers under WIC can prevent smaller competitors from entering the market.
When a factory supplying a significant portion of baby formula was shut down, the government had to source formula from other countries to meet demand.
Health Insurance:
Increased government expenditure on public healthcare can reduce the demand for private health insurance.
As the public system improves in terms of quality and coverage, consumers may opt for the more affordable public option, causing private insurers to lose customers.
Some employers may also stop offering private health insurance to their employees due to rising costs.
Venture Capital:
Government borrowing can compete with private venture capital firms for finite capital.
This competition can lead to higher interest rates and reduced venture capital investment.
However, in some cases, increased government spending on public capital can raise returns for private venture capital, encouraging private firms to participate (crowding-in).
Agriculture:
Government subsidies to farmers can impact private agricultural markets.
Subsidized crops may flood the market, affecting prices and profitability for private farmers producing the same crops.
Higher Education:
Increased government funding for public universities can lead to reduced demand for private universities.
As public institutions offer competitive tuition rates, private colleges may struggle to attract students.
Energy:
Government investments in renewable energy projects, like solar and wind farms, can discourage private sector investments in the same technologies.
Private companies may perceive government-backed projects as competition.
Banking and Finance:
When governments nationalize or heavily regulate banks, private financial institutions may face reduced opportunities for growth.
Government-backed banks may have advantages that crowd out private sector competition.
Real Estate:
Government initiatives to provide affordable housing or low-interest loans can affect private property developers.
These programs can alter market dynamics and create challenges for private developers in the same space.
Transportation:
Public transportation systems, heavily subsidized by the government, may discourage private sector investment in similar services.
Private bus or taxi companies may struggle to compete with government-funded public transit.
Pharmaceuticals:
Government healthcare programs that negotiate drug prices with pharmaceutical companies can impact private sector drug pricing.
Lower government-negotiated prices may limit the profitability of private pharmaceutical companies.
Technology and Innovation:
Government research and development (R&D) initiatives in certain technology sectors can crowd out private sector R&D investments.
Private tech firms may face increased competition from government-funded projects.
Key Highlights
Definition: The crowding-out effect occurs when public sector spending reduces spending in the private sector.
How It Works:
It describes how government spending can lead to a reduction in private sector spending.
Government spending is typically funded by increasing taxes or borrowing, which reduces available capital and consumer confidence.
In the long term, the crowding-out effect can hinder economic growth and exacerbate fiscal issues.
Government Spending and Aggregate Demand:
Governments engage in spending to increase aggregate demand for goods and services among consumers.
Paradoxically, public spending is theorized to decrease aggregate demand.
Financing Government Spending:
Government spending is financed through increased taxes, which reduce disposable income and demand for goods and services.
It’s also financed through borrowing, which diverts private sector capital into government bonds, reducing funds available for private sector investment.
Impact on Capital and Interest Rates:
The crowding-out effect reduces the total savings available for investment.
As public spending increases, it raises demand for available capital while the total capital remains constant.
This can lead to higher interest rates, making it difficult for individuals and businesses to access capital.
Economic Consequences:
Decreases in private sector spending on goods and services can slow economic growth.
Fiscal stimulus packages during recessions may result in consumers saving rather than spending, rendering them less effective.
Cyclical Nature:
Government spending intended to address economic shortfalls can create a negative cycle where more capital is spent to stimulate a crowded-out private sector.
An increase in welfare spending during recessions can lead to higher taxes and interest rates, reducing discretionary income and increasing reliance on welfare.
Examples:
Resources: Government purchase of a significant portion of a resource supply can disrupt private sector production, common in wartime.
Infrastructure: Government infrastructure investment can discourage private sector participation due to limited access to capital.
Consumer Products: Government programs, like WIC in the U.S., can limit competition in markets like baby formula.
Health Insurance: Increased public healthcare spending can lead to reduced demand for private health insurance.
Venture Capital: Government borrowing can compete for finite capital, leading to reduced venture capital investment, but in some cases, it can also encourage private firms to participate (crowding-in).
Venture Capital Example:
A study in Canada found that a government initiative to fund new companies, underpinned by Labour Sponsored Venture Capital Corporations (LSVCCs), actually decreased the aggregate pool of venture capital.
LSVCCs had geographical and financial constraints, leading to poor investment decisions, and capital raised but not invested.
Private venture capital was crowded out, resulting in fewer businesses being created.
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Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
