Friday, June 25, 2010

The "crowding out" concept is irrelevant.

First, definitions. The word government is used below to refer to politicians, bureaucrates, the legislature and central bank all combined. The actual extent of central bank independence varies from country to country, and within a given country, from decade to decade. Thus treating government and central bank as one unit is legitimate, at least for some purposes.

Crowding out is where government borrows $X with a view to spending the $X (or thereabouts), and the fact of borrowing drives up interest rates (or makes borrowing for the private sector more difficult for other reasons) which in turn reduces private sector spending.

In some cases, crowding out is desirable. E.g. given more or less full employment, and given a desire to expand the public sector relative to the private sector, a portion of the latter’s share of GDP obviously has to be crowded out, else spending in aggregate is excessive.

In this instance, crowding out is not a problem: it is irrelevant.

In contrast, in a recession, governments borrow and spend with a view to stimulus. Crowding out would occur if government allowed interest rates to rise as a result of the additional borrowing. But governments are hardly likely to do this, are they? Indeed, they’ll most likely cut interest rates. Indeed, if they let rate rise, they’re just cutting their noses to spite their faces. So crowding out doesn’t occur.

So the relevance of the “crowding out” concept is what? Anyone know?

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