Crowding out: what's the evidence?

Before the publication of Keynes' General Theory, most marginalist economists were against expansionary fiscal policy. It was believed that an increase in government spending would reduce by the same amount private spending, and, hence, it would have no effect on output and employment. Keynes referred to this as the Treasury View, since bureaucrats at the Treasury were prone to believe it. This has been known as crowding-out in more recent times.The evidence is not particularly forthcoming, as far as I can tell.

Amazingly, given the relevance of the topic for conservative ideas, and the fact that this is still the reason why the fear of deficits and debt is so pervasive, there is not much research on the effects of deficits on interest rates. Robert Murphy, on the Instructor's Resources for Mankiw's manual (funny that is NOT in the manual) says:
"Economists worry, therefore, that high deficits imply low levels of investment, leading ultimately to a lower capital stock and so lower living standards. It is, therefore, important to see if this prediction that high deficits lead to high interest rates is supported by the data. Like many empirical questions in economics, this one is difficult to answer unequivocally. Figure 1 shows a scatterplot of the real government deficit and the ex post real interest rate between 1960 and 2000. While there is some evidence of a positive association, it is not strong."
The graph below.
Updating the graph for 1962 to 2014, with CPI for deflating the rate of interest, I've got the following graph:
There is a very weak, and statistically insignificant relation between deficits and the real rate of interest (note that in mine deficits are negative). In my view, this suggests that there is no clear relation. Deficits do not seem to impact the rate of interest, and crowding out is not empirically relevant. There are plenty theoretical reasons for not believing in it too. And Ricardian Equivalence is NOT one of those. But that would be material for another post.

PS: The weak correlation remains even if one adjusts for outliers, by the way. So no there is nothing there, and that's why there isn't much in the mainstream published on this.


  1. Govt spending adds dollars to the economy
    Govt taxation removes dollars from the economy
    Therefore, Govt deficits = net addition of dollars to the economy

    So how in the world can deficits crowd out the private sector when they add dollars? As far as empirical questions go, it doesnt get any easier than this. Just another in a long line of examples of how unbelievably irrelevant mainstream economics is, that people still believe something so obviously false.

    1. The rate of interest going up, that would be the traditional response. There isn't much evidence for that.

    2. $ injections drive down interest rates by definition as QE demonstrates. Thats the purpose of issuing securities, to remove excess reserves from the federal funds market. So deficits are neutral wrt interest rates when accompanied by dollar for dollar securities issuance. Accounting is all the evidence we need to understand this process.

    3. Hi Auburn, yes open market operations are used to control the rate of interest, and as you note in some circumstances (not common) the Fed tries to control the long run rate. But that is hardly evidence. Not just because normally the Fed controls just the short rate, but more importantly because there is a secondary market for bonds, and arguably it could happen that as fiscal deficits increase, bond holders demand higher rates of interest in order to hold long term bonds. Again, the evidence for that is weak at best, and the Fed could, even in those circumstances, intervene to bring the long term down, as they did during the Great Depression, and more recently.

    4. "Not just because normally the Fed controls just the short rate, but more importantly because there is a secondary market for bonds, and arguably it could happen that as fiscal deficits increase, bond holders demand higher rates of interest in order to hold long term bonds"

      TSY is under no obligation to issue long term securities, even if that were to happen (which it never has in a floating FX regime), TSY could isssue nothing but 3-mo T-bills if it wanted to. Thats what being sovereign means, the govt is in control of its finances. If the Fed were to announce a permanent ZIRP policy, 10 year T-note rates would never go to 10% unless inflation got that high. Deficits by themselves have nothing to do with longer term interest rates. Long term rates are a function of Fed FFR expectations + inflation expectations, so maybe you could make the argument that large deficits beyond full employment driving high inflation would cause increased rates or expectations that because of high inflation that the Fed was going to raise the FFR that high per its reaction function. But what does any of this have to do with crowding out?

  2. ...and besides this, there is the fact that the interest rate has little or no effect on private non-residential investment. So even if higher deficits implied higher interest rates (which is false, as your post argues), this would discourage perhaps some residential investment and consumer credit, but not productive investment. Your post made me wonder whether it was this lack of evidence for crowding out of investment which led neoclassical macroeconomists to explore other ways to deny the positive effect of public deficits, like lifetime-income models in which deficits depress private consumption and so on.


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