I was teaching economics in my CFA Level I Batch for the Dec 2020 session. As I was discussing the national debt to GDP ratio of a country, there were two arguments about whether we should be concerned about the national debt. While discussing the arguments in favor of being concerned about the national debt, the term crowding out comes in. When government budget deficits rise too much, government borrowing may divert private sector investment from taking place. This effect is known as the “Crowding Out” effect. So, the crowding out refers to how fiscal deficits impact the economy, financial system, interest rates, and inflation. When the government spends money, it must compete with the private sector to get its hands on whatever it is trying to buy.  The term crowding out refers specifically to how the government extracts resources from the private sector to pay its bills and what the consequences are.

There are four ways the government can extract extra resources from the private sector. Each of them has consequences in the economy. 

Raise Taxes

When there is rising public debt because of continuous fiscal deficits, there is a question about how to pay for those rising public debts. One way to repay the debt is to raise taxes later. However, raising taxes is difficult and politically unpopular. Most governments are not very successful at raising much more money by raising taxes. Also, when an economy is undergoing a recession,  raising taxes can quickly undermine the economic recovery.

The increasing public debt also impacts how people behave. People know that the rising deficits and debts have to be financed out of new borrowings. People know that someone has to pay at some point and that could be them or the next generation. People and businesses begin to predict a rise in the tax burden in the future and adjust their spending accordingly. This is called Ricardian Equivalence. 

This can have a negative effect on the economy in the near term because people will save more, either to pay future taxes or just to hedge against increased uncertainty. It is generally believed that the higher the government debt ratio is, the stronger the Ricardian Equivalence factor. In the extreme, a dollar of extra government spending may cause people to cut their spending by more than a dollar, and GDP could actually fall.

Government Borrowing

When there is rising fiscal deficits, the government often finances the deficits through increased borrowing. The increased government borrowing will force up interest rates to the point where marginal private borrowers can’t compete.  Higher interest rates would also increase interest payments to foreigners and reduce capital spending, which lowers living standards in the future. It would raise the cost of servicing government debt, which would compound the escalating government debt-to-GDP ratio, further crowding out the private sector. Higher interest rates raise residential mortgage and other consumer credit costs as well.

Use Extensive Controls

The government may use extensive controls on things like wages, prices, and interest rates. People expect this in wartime and acquiesce. During World War II, many countries used controls effectively.  In the postwar period, the U.S. government tried wage and price controls in the early 1970s and credit controls in the early 1980s.

Debt Monetization

The Government can create additional money by selling bonds to the Federal Reserve and the banking system. Experience has shown that some countries have even used force to make central banks give them currency to pay their bills. For example,  Argentina at the end of 2009 tried to raid the central bank’s foreign exchange reserve to pay its bills and fired the governor when he refused. These are extreme cases and highlight the sort of financial dramas that can occur when governments run out of the ability to pay their bills.

In summary, we can say that deficits can create problems, and big deficits, if not brought under control, may create enormous problems. Governments cannot extract extra resources from the economy without having serious consequences. When the economy is depressed and the government’s fiscal capacity is ample, the consequences are minimal and reversible if the government runs surpluses after the economy recovers. This was John Maynard Keynes’s prescription—balance the budget over the business cycle with deficits in recessions and surpluses in booms.