The alleged crowding out effect

Let's talk about crowding out. Before our economy recovers, some prominent economists -- America's "serious people" -- are going to be speaking about the risk of government debt crowding out productive private investment in America's economy. They will sound serious and maybe even credible. If they are listened to, millions of Americans will suffer unnecessarily.

Jamie Powell at FT Alphaville introduces the topic nicely:

If you've had the misfortune of having to learn economics, you may remember the theory of the "crowding out effect" from your studies. Popularized in the 1970s, the idea is that an increase [in] public sector investment, and therefore borrowing, has the rather undesirable effect of displacing the private sector's planned borrowing and investment.

Essentially, the theory goes like this: If government finances programs by issuing bonds (i.e., with higher deficits), then interest rates will rise, the projects the private sector is planning will become less profitable due to a higher cost of capital, and some of those projects won't go ahead. The result is lower overall private sector investment, which means lower growth and productivity, ultimately resulting in lower long-run GDP. Fine in theory (with certain very strong assumptions, to be described in a later post), but it doesn't describe reality.

As one example of the fantasy foundations of crowd out theory, Powell quotes a new working paper by Enrico Moretti, John Van Reenen, and Claudia Steinwender. They find that public sector R&D expenditure -- directly or through subsidies -- leads to an increase in private sector spending in R&D, a "crowding in" effect. To those who have followed the work of Mariana Mazzucato and Bill Janeway (and, more recenty, the Council on Foreign Relations), this result will not come as a surprise. A quick glance at the development of industries such as information technology (core technologies of the internet, computers, iPhones, etc. all came through government-sponsored research and were supported by government as an early-stage customer), pharmaceuticals (over 75 percent of new molecular entities -- the truly novel drugs -- are discovered by government-funded researchers), and trains in the 19th century (the railroad boom was made possible in part by government granting 9 percent of US land to corporations) makes clear that there is more to crowd out than the neoliberal story of supply and demand for a fixed amount of national savings in an economy operating at full capacity in which the technological innovations that lead to productivity growth and the corresponding increases in per capita wealth magically occur .

I have nothing to add on those points beyond what is described by economists such as Mazzucato and Janeway. But here I point out one more thing: crowd out theory was created a couple of centuries before it was popularized in the 1970s, when money and taxes were very different from today. Here is Thomas Piketty summarizing 18th tax receipts in Capital and Ideology (p. 364)

In the centuries that followed these sums [tax receipts] would grow spectacularly, mainly due to the intensifying rivalry between England and France: both countries were taking in 600-900 tons of silver in 1700, 800-1,100 tons in the 1750s, and 1,600-1,900 tons in the 1780s, leaving all other European powers far behind. Importantly, Ottoman tax receipts remained virtually unchanged from 1500 to 1780: barely 150-200 tons.

Two points from this:

1. When people say that government spending will "crowd out" public investment, they are reasoning from an intellectual framework developed in the 18th century, when countries measured their tax receipts in tons of silver. That framework has not been updated for today's market-based model of banking and money creation.
2. The empire with the least amount of government spending and hence "crowding out" (even when the theory was more relevant) was the declining one. I don't explore this point further in this post, but there's a chance it's not insignificant.

Following up on the first point, here is one example of the differences. When the English Crown took in ~1,000 tons of silver from its subjects in 1760, there were 1,000 fewer tons of silver for (a) England's banks to issue currency, (b) its merchants to invest in sailing to India for tea and spices, and (c) its early industrialists to invest in building new textile mills. If King George collected silver to build a new summer palace at the expense of a new textile mill, crowd out was real! Today, if the US Treasury decides to send $1 trillion to Americans, there are not 1 trillion fewer dollars for productive private investment (and, I would argue, this is a better use of money than a new summer palace for George, but that is beside the point here). [I'm still trying to find out if anyone is operating with an updated framework for these types of questions].

Of course, we have to manage our nation's finances wisely. We (probably) can't exceed our productive capacity indefinitely. Eventually, inflation would increase and/or we would face other issues. But that is a discussion for later.

The point here is, if someone says crowd out with a straight face, do not take them seriously. Unless, of course, that person is a "serious person" who many people listen to. In that case, take him/her very seriously: she's dangerous.