Can Government Spending Cripple Private Sector Growth
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Crowding out occurs when expansionary fiscal policies cause interest rates to rise or taxes to increase, thereby reducing private spending, particularly investment. This article attempts to analyze if the enormous U.S. Government spending plan will cripple the private sector growth and if the economy will perform way below its potential output as a result of the Government overspending.
There are several ways in which increased Government spending can lead to the private sector cutting back on its spending and expansion. To analyze each of these factors we need to understand how the Government gets money to fund its spending programs. The alternatives for the Government are few and easy to understand.
Impact of Higher Taxes on Private Sector
The Government might chose to raise taxes in order to fund its increased expenditure. In this case, the corporates have to give higher taxes on their profits which leaves them with relatively lesser amount to spend on their growth and expansion.
Higher taxes on individuals can also have a negative impact on the private sector. Higher individual taxes will cause the disposable income for an individual to fall. This in turn will impact their spending decision. Any decline in consumption directly impacts the private sector growth.
So if the Government chooses to go for higher taxes in order to fund their spending, they might be doing more harm then good to the economy in general.
Moreover, we all know how efficient the Government sector is as compared to the private sector. So it would not be difficult to determine the direction of the economy of a country where the Government is getting bigger and the private sector is shrinking.
Impact of Government Borrowing on the Private Sector
If the Government sells its bonds to the private sector then its sucking out liquidity from the private sector and utilizing it to fund its spending. This has a direct impact on the growth and investment plans of the private sector as they has lesser funds in place for their growth.
However, even if the Government borrows funds from other countries, it impacts the growth of the private sector. The process is as follows:
The Government might be able to borrow funds from abroad but for that it needs to set attractive terms for bond buyers. This is especially true for a Government which is already overburdened with debt. So as the emerging economies recover and inflation gets higher, these countries will demand much higher interest payments on the bonds. No one would love to buy bonds which give negative returns (when adjusted for inflation).
The U.S. Government will thus be forced at one point of time to increase rates on bonds and this will lead to interest rates going up in general. Higher price for money again impacts the private sector as it might not be able to borrow funds (or borrow to the extent it needs) for its expansion.
Thus, even by selling bonds to other countries, the Government might impact the provate sector spending through higher interest rates. In order to keep interest rates low, the only option the Government will have is to monetize debt (print money).
Impact of Debt Monetization on the Private Sector
Debt Monetization is the best way to cause spiralling inflation and also accelerate the demise of any currency. Thus, debt monetization might ultimately lead to the same higher interest rates or a bigger crisis for the financial and economic system as a whole.
Does Government spending only lead to Negatives?
One might be wondering at this point of time that is there any positive associated with Government spending and if not then whey are Governments creating huge deficits which ultimately will lead to no benefit for anyone.
The answer is that Government spending is not something which always spells disaster. But the following things have to be taken into consideration.
There are several ways in which increased Government spending can lead to the private sector cutting back on its spending and expansion. To analyze each of these factors we need to understand how the Government gets money to fund its spending programs. The alternatives for the Government are few and easy to understand.
- The Government will increase taxes for individuals and corporates which will result in higher revenue for the Government. The Government can then fund its excess expenditure using these receipts.
- The Government can borrow money by selling Government bonds. These bonds can be sold to corporates in the country or to other countries.
- The Government can monetize debt. In this case, the money is not received from any of the above two sources. Money is just printed (created out of thin air).
Impact of Higher Taxes on Private Sector
The Government might chose to raise taxes in order to fund its increased expenditure. In this case, the corporates have to give higher taxes on their profits which leaves them with relatively lesser amount to spend on their growth and expansion.
Higher taxes on individuals can also have a negative impact on the private sector. Higher individual taxes will cause the disposable income for an individual to fall. This in turn will impact their spending decision. Any decline in consumption directly impacts the private sector growth.
So if the Government chooses to go for higher taxes in order to fund their spending, they might be doing more harm then good to the economy in general.
Moreover, we all know how efficient the Government sector is as compared to the private sector. So it would not be difficult to determine the direction of the economy of a country where the Government is getting bigger and the private sector is shrinking.
Impact of Government Borrowing on the Private Sector
If the Government sells its bonds to the private sector then its sucking out liquidity from the private sector and utilizing it to fund its spending. This has a direct impact on the growth and investment plans of the private sector as they has lesser funds in place for their growth.
However, even if the Government borrows funds from other countries, it impacts the growth of the private sector. The process is as follows:
The Government might be able to borrow funds from abroad but for that it needs to set attractive terms for bond buyers. This is especially true for a Government which is already overburdened with debt. So as the emerging economies recover and inflation gets higher, these countries will demand much higher interest payments on the bonds. No one would love to buy bonds which give negative returns (when adjusted for inflation).
The U.S. Government will thus be forced at one point of time to increase rates on bonds and this will lead to interest rates going up in general. Higher price for money again impacts the private sector as it might not be able to borrow funds (or borrow to the extent it needs) for its expansion.
Thus, even by selling bonds to other countries, the Government might impact the provate sector spending through higher interest rates. In order to keep interest rates low, the only option the Government will have is to monetize debt (print money).
Impact of Debt Monetization on the Private Sector
Debt Monetization is the best way to cause spiralling inflation and also accelerate the demise of any currency. Thus, debt monetization might ultimately lead to the same higher interest rates or a bigger crisis for the financial and economic system as a whole.
Does Government spending only lead to Negatives?
One might be wondering at this point of time that is there any positive associated with Government spending and if not then whey are Governments creating huge deficits which ultimately will lead to no benefit for anyone.
The answer is that Government spending is not something which always spells disaster. But the following things have to be taken into consideration.
- What is the Government Spending directed towards? In the cae of U.S, the Government spending is directed towards encouraging consumption instead of encouuraging capital formation and private fixed investments. The Government is trying to find the solution to the problem by using the problem itself as the medicine. Thus, in my opinion, a large part of the Government spending is misdirected and that will not benefit the economy in a big way. The only thing it can do is to artifically support the economy.
- The Government also needs to consider how much leverage it alread has. For a country, which has record debt and deficits, it makes little sense to borrow and try to spend their way out of recession.
Private Fixed Investment Trend in U.S.
As it is clear from the chart above, the fixed private investment has slumped in the current recession to its worst since the 1950's. This corrosponds to the biggest spending spree by the Government in decades.
But output gap estimates for 2009 and 2010 does not show any big positive impact of the Government spending on the economy performing above its potenital or anywhere near its potential.
Output Gap Estimates for 2009 and 2010
Thus, flooding the system with liquidity is not always the solution to the problem. It might just create even more problems.
For years there has been excessive spending in the Developed world that was funded by savings in the Emerging countries (as indicated by their respective trade deficits and surpluses). This trend might just change with this crisis. The Americans need to save more, consume less and also produce more. This needs more fixed investments by the private sector.
The Government would do best if it allows free markets to work and create policies for a competitive private sector enviornment. These measures might lead to prolonged recession but help a great nation emerge out stronger from the crisis.
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The Government would do best if it allows free markets to work and create policies for a competitive private sector enviornment. These measures might lead to prolonged recession but help a great nation emerge out stronger from the crisis.
Recent Articles in Stock Markets and Economic Analysis:
Interesting Technical Views on Indian and U.S. Markets
Permanent Link To This Post
Faisal, the post is very informative. Thanks for sharing your views. A nation cant come out of a pit by digging deeper. How can government spending be justified when the people spending money pushed it into the pits.
Madan Kumar Rajan
Faisal, thanks for showing these charts, these are most interesting charts that I've not seen. Adding some thoughts and one question.
1. Without a doubt, Private Fixed Investment in USAs % change is worse by a large margin than any prior period. Question: Are these charts for the period ending in August ?
2. I believe there are long-term trends at play over and above the current recession impacting the first chart. One would need to research the definition of what qualifies as a "Private Fixed Investment" and where the government gets their data but it's no secret America's largest multi-nationals have been expanding more outside of America than in America. In the last four years many major US based international Oil service companies like TransOcean(RIG)has moved its headquarters out of the US. A decade of extra low American capital gains rate combined with ultra low interest rates in America simply resulted in more ( private investment) American Shopping Malls, big SUVs, Mega-Casinos and the world's best new Sports Arenas but I do not recall any new factories being built that produced durable or consumable goods to sell. Few jobs outside of the housing and financial service boom related industry were created. Now those are mostly gone. I believe one exception was an Intel Chip factory built in New Mexico.
3. China has positioned itself as the worlds factory and India has become the world's IT and Business Back Office outsource center and now India is becoming the western worlds refiner.
4. Just one interesting example (of where the Private Investment is going) is the fact that America the world's biggest consumer of gasoline has not built a new refinery plant in the USA in 30 years ( many old ones were closed). Reliance Petroleum Ltd. (RPL) of India has built a $6 billion state-of-the-art oil refinery and petrochemical complex in Jamnagar Gujarat, India, using U.S. equipment, technology and services financed by a $500 million loan guarantee from the Export-Import Bank of the United States. RPL's primary shareholder, Reliance Industries Ltd. (RIL), I believe is one of India's largest private companies. The new refinery is the world's sixth largest and will be located adjacent to RIL's existing refinery and petrochemical complex in Jamnagar. Together the two refineries will comprise the largest refining complex in the world. It's my understanding that at least 80% of the refined oil is being exported to Europe and America.
5. Reliance owns nearly 25% of the world’s complex refining capacity. Reliance now operates the largest refining complex at one site globally. It has enabled Jamnagar to become the refining capital of the world. Reliance is the only company in the world to have built two large super-size complex refineries in the last decade. Reliance is now among the largest producer of ultra clean fuels in the world. Reliance is the only large refining company in the world today that operates its facilities in excess of 100% of rated capacity.
6. While all Austrian School Economist, American Libertarians' and The Cato Think Tank type organizations would agree with the notion government should say out I was required to study under American Neo-Keynesian economist, Paul Samuelson so my views are supportive of Keynesian thinking. But I'd bet Keynes would prefer move large scale infrastructure projects spending in America over building shopping malls and encouraging people to buy more stuff and bigger homes.
Thanks much for your comment and really interesting points.
The data for fixed investment trend is till the second quarter of 2009. However, in my opinion, the trend will not be very different in the third quarter as well.
For sure the current problem with China is overcapacity and with U.S. is over consumption. The same reflects in their deficits.
In general, U.S. needs to save more and also produce more as yo also pointed out. But unfortunately the Government is primarily concerned with the consumption spree starting all over again.
The reason is that if savings increase, capital investments increase and production increases...the transition will be a very painful one. But it will be a healthy one. But a country with huge deficits cant afford a long recession.
"But I'd bet Keynes would prefer move large scale infrastructure projects spending in America over building shopping malls and encouraging people to buy more stuff and bigger homes."
I am in complete agreement with your point above. If the government packages were directed towards these areas then it would have been much more beneficial.
But you can see what is happening in reality. Banks are not lending...consumers wud also not really want to leverage more...On top of that huge speculation is going on in all asset classes with bailout funds.
This really does not benefit the economy. What it does is that it gives a feel good factor when markets go up.
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