Crowding out

A further criticism levelled at the Keynesian fiscal policy is the risk of crowding out. This is the idea that government spending may squeeze out consumption and investment by the private sector, so that the growth in aggregate demand from an increase in G is at least partially offset by a fall in C and/or I.

A key proponent of the idea that government spending may crowd out consumption is the economist Roger Farmer. His arguments start with a way of looking at the consumption function that is different from the familiar Keynesian one in which consumption is determined largely by income (Farmer and Plotnikov, 2012). The alternative is based on an approach developed by Milton Friedman called the permanent income hypothesis (Friedman, 1957, pp. 21–2). In Friedman’s view, consumption is closely linked to wealth rather than income. People take a long view and set a normal level of consumption according to their wealth. This means that people may borrow now to support a high standard of living if they expect their earnings to rise in future (because of, say, the anticipated rewards from their education, training and experience), or they may limit their consumption now in order to save enough for a comfortable lifestyle later when income is expected to drop (typically after retiring).

The gist of Farmer’s argument is that if the government announces an increase in government spending, G, then households will expect this to mean a rise in taxes, T, later (whether to bring the government’s budget back into balance or to pay off government debt used to fund the increase in G). Given their long view, households will offset the gain to themselves from G today against the future loss in T – and so increase their savings to cover the expected future tax bill rather than increasing consumption, thus partially or completely offsetting the rise in G.

Barro (1981) also points out that many types of government spending can be seen as close substitutes for private-consumption goods – for example, a public health service (like the NHS in the UK) is a substitute for private medical care, unemployment benefits are a substitute for private insurance, publicly funded schools and universities are substitutes for private education, and so on. If the government increases spending on these types of items, then consumers will cut back on the amount that they spend privately on similar items.

Keynes offered an explanation of how government borrowing to fund a rise in G could crowd out private investment:

If the government issues too many bonds, then it may have to increase the rate of interest in order to find buyers. This is what happened to Greece and Italy, from around 2010. The high interest rate in these countries would have had an adverse impact on the level of private investment; hence some would argue that government overspending crowded out the private sector.

However, for some countries, such as the UK and the USA, this argument may not apply. For some time after the 2008 crisis, interest rates languished at low levels, despite high deficits. Economies are often more complicated. A major factor determining the effectiveness of fiscal policy is the confidence that international markets have in government-issued debt and animal spirits. As Keynes puts it: