crowding-out-effect

Crowding-Out Effect And Why It Matters

The crowding-out effect occurs when public sector spending reduces spending in the private sector.

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:

  1. Increasing tax – taxes imposed on consumers and businesses reduce the amount of discretionary income, thereby reducing demand for goods and services.
  2. 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.

When a factory supplying 43% of baby formula in the USA was shut down for unsanitary practices and damage caused by torrential rain, the government was forced to look elsewhere for the product.

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.

According to an estimate by the Canadian Venture Capital Association, around 45% of the $7.2 billion in LSVCC capital under administration was 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.

Connected Thinking Frameworks

Convergent vs. Divergent Thinking

convergent-vs-divergent-thinking
Convergent thinking occurs when the solution to a problem can be found by applying established rules and logical reasoning. Whereas divergent thinking is an unstructured problem-solving method where participants are encouraged to develop many innovative ideas or solutions to a given problem. Where convergent thinking might work for larger, mature organizations where divergent thinking is more suited for startups and innovative companies.

Critical Thinking

critical-thinking
Critical thinking involves analyzing observations, facts, evidence, and arguments to form a judgment about what someone reads, hears, says, or writes.

Systems Thinking

systems-thinking
Systems thinking is a holistic means of investigating the factors and interactions that could contribute to a potential outcome. It is about thinking non-linearly, and understanding the second-order consequences of actions and input into the system.

Vertical Thinking

vertical-thinking
Vertical thinking, on the other hand, is a problem-solving approach that favors a selective, analytical, structured, and sequential mindset. The focus of vertical thinking is to arrive at a reasoned, defined solution.

Maslow’s Hammer

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Maslow’s Hammer, otherwise known as the law of the instrument or the Einstellung effect, is a cognitive bias causing an over-reliance on a familiar tool. This can be expressed as the tendency to overuse a known tool (perhaps a hammer) to solve issues that might require a different tool. This problem is persistent in the business world where perhaps known tools or frameworks might be used in the wrong context (like business plans used as planning tools instead of only investors’ pitches).

Peter Principle

peter-principle
The Peter Principle was first described by Canadian sociologist Lawrence J. Peter in his 1969 book The Peter Principle. The Peter Principle states that people are continually promoted within an organization until they reach their level of incompetence.

Straw Man Fallacy

straw-man-fallacy
The straw man fallacy describes an argument that misrepresents an opponent’s stance to make rebuttal more convenient. The straw man fallacy is a type of informal logical fallacy, defined as a flaw in the structure of an argument that renders it invalid.

Streisand Effect

streisand-effect
The Streisand Effect is a paradoxical phenomenon where the act of suppressing information to reduce visibility causes it to become more visible. In 2003, Streisand attempted to suppress aerial photographs of her Californian home by suing photographer Kenneth Adelman for an invasion of privacy. Adelman, who Streisand assumed was paparazzi, was instead taking photographs to document and study coastal erosion. In her quest for more privacy, Streisand’s efforts had the opposite effect.

Heuristic

heuristic
As highlighted by German psychologist Gerd Gigerenzer in the paper “Heuristic Decision Making,” the term heuristic is of Greek origin, meaning “serving to find out or discover.” More precisely, a heuristic is a fast and accurate way to make decisions in the real world, which is driven by uncertainty.

Recognition Heuristic

recognition-heuristic
The recognition heuristic is a psychological model of judgment and decision making. It is part of a suite of simple and economical heuristics proposed by psychologists Daniel Goldstein and Gerd Gigerenzer. The recognition heuristic argues that inferences are made about an object based on whether it is recognized or not.

Representativeness Heuristic

representativeness-heuristic
The representativeness heuristic was first described by psychologists Daniel Kahneman and Amos Tversky. The representativeness heuristic judges the probability of an event according to the degree to which that event resembles a broader class. When queried, most will choose the first option because the description of John matches the stereotype we may hold for an archaeologist.

Take-The-Best Heuristic

take-the-best-heuristic
The take-the-best heuristic is a decision-making shortcut that helps an individual choose between several alternatives. The take-the-best (TTB) heuristic decides between two or more alternatives based on a single good attribute, otherwise known as a cue. In the process, less desirable attributes are ignored.

Biases

biases
The concept of cognitive biases was introduced and popularized by the work of Amos Tversky and Daniel Kahneman in 1972. Biases are seen as systematic errors and flaws that make humans deviate from the standards of rationality, thus making us inept at making good decisions under uncertainty.

Bundling Bias

bundling-bias
The bundling bias is a cognitive bias in e-commerce where a consumer tends not to use all of the products bought as a group, or bundle. Bundling occurs when individual products or services are sold together as a bundle. Common examples are tickets and experiences. The bundling bias dictates that consumers are less likely to use each item in the bundle. This means that the value of the bundle and indeed the value of each item in the bundle is decreased.

Barnum Effect

barnum-effect
The Barnum Effect is a cognitive bias where individuals believe that generic information – which applies to most people – is specifically tailored for themselves.

First-Principles Thinking

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First-principles thinking – sometimes called reasoning from first principles – is used to reverse-engineer complex problems and encourage creativity. It involves breaking down problems into basic elements and reassembling them from the ground up. Elon Musk is among the strongest proponents of this way of thinking.

Ladder Of Inference

ladder-of-inference
The ladder of inference is a conscious or subconscious thinking process where an individual moves from a fact to a decision or action. The ladder of inference was created by academic Chris Argyris to illustrate how people form and then use mental models to make decisions.

Six Thinking Hats Model

six-thinking-hats-model
The Six Thinking Hats model was created by psychologist Edward de Bono in 1986, who noted that personality type was a key driver of how people approached problem-solving. For example, optimists view situations differently from pessimists. Analytical individuals may generate ideas that a more emotional person would not, and vice versa.

Second-Order Thinking

second-order-thinking
Second-order thinking is a means of assessing the implications of our decisions by considering future consequences. Second-order thinking is a mental model that considers all future possibilities. It encourages individuals to think outside of the box so that they can prepare for every and eventuality. It also discourages the tendency for individuals to default to the most obvious choice.

Lateral Thinking

lateral-thinking
Lateral thinking is a business strategy that involves approaching a problem from a different direction. The strategy attempts to remove traditionally formulaic and routine approaches to problem-solving by advocating creative thinking, therefore finding unconventional ways to solve a known problem. This sort of non-linear approach to problem-solving, can at times, create a big impact.

Bounded Rationality

bounded-rationality
Bounded rationality is a concept attributed to Herbert Simon, an economist and political scientist interested in decision-making and how we make decisions in the real world. In fact, he believed that rather than optimizing (which was the mainstream view in the past decades) humans follow what he called satisficing.

Dunning-Kruger Effect

dunning-kruger-effect
The Dunning-Kruger effect describes a cognitive bias where people with low ability in a task overestimate their ability to perform that task well. Consumers or businesses that do not possess the requisite knowledge make bad decisions. What’s more, knowledge gaps prevent the person or business from seeing their mistakes.

Occam’s Razor

occams-razor
Occam’s Razor states that one should not increase (beyond reason) the number of entities required to explain anything. All things being equal, the simplest solution is often the best one. The principle is attributed to 14th-century English theologian William of Ockham.

Mandela Effect

mandela-effect
The Mandela effect is a phenomenon where a large group of people remembers an event differently from how it occurred. The Mandela effect was first described in relation to Fiona Broome, who believed that former South African President Nelson Mandela died in prison during the 1980s. While Mandela was released from prison in 1990 and died 23 years later, Broome remembered news coverage of his death in prison and even a speech from his widow. Of course, neither event occurred in reality. But Broome was later to discover that she was not the only one with the same recollection of events.

Crowding-Out Effect

crowding-out-effect
The crowding-out effect occurs when public sector spending reduces spending in the private sector.

Bandwagon Effect

bandwagon-effect
The bandwagon effect tells us that the more a belief or idea has been adopted by more people within a group, the more the individual adoption of that idea might increase within the same group. This is the psychological effect that leads to herd mentality. What in marketing can be associated with social proof.

Read Next: BiasesBounded RationalityMandela EffectDunning-Kruger

Read Next: Bounded RationalityHeuristics

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