How does government “crowd out” or “crowd in” the private sector?
The role of the state in economic growth is a debate almost as old as economics itself.
Whether and how government spending or investment crowds in, or indeed crowds out, private sector activity or investment is an ongoing political and economic debate. This debate is not only occurring in New Zealand but is also a live one in developed economies. Following record government support to the economy during the COVID-19 pandemic, governments are grappling with how to rebalance their books while maintaining economic momentum.
Notably, following its latest election, Germany is bucking the trend. Notorious for its public spending conservatism (going as far as inscribing into law a debt brake on its governments), it is making a historical change in its fiscal tradition and is planning to invest as much as one trillion euros. Conversely, across the Atlantic, a focus of the Trump administration is to curtail US government spending and reduce its large and growing fiscal deficit.
The crowding effect, whether in or out, tends to be oversimplified
The crude and oversimplified crowding out argument is that government spending boosts the economy, causing inflation and interest rates to rise. This in turn dampens private investment and, ultimately, overall economic performance.
Conversely, the crude and oversimplified crowding in argument is that government spending boosts the economy and fosters a more active and confident economic environment for the private sector to spend and invest.
What is the net crowding effect? The short, and somewhat unsatisfactory, answer is that it depends. Several factors influence the answer to this question, including current economic conditions. Is increased government spending funded through tax or debt? Is the economy in recession, stagnating, or growing? Is the government spending in the form of welfare or infrastructure investment? All of these factors matter.
Ultimately, government spending doesn’t universally crowd in or crowd out the private sector. Crowding effects are a matter of economic policy sophistication that takes into consideration domestic and international economic circumstances.
A brief review of the New Zealand experience
To illustrate by reviewing the New Zealand experience, the following chart shows annual growth in government and private sector spending over the past two decades.
Government and private sector spending have at times moved in opposite directions, particularly during recessions when private sector activity slows, and the government spends to stabilise the economy.
But they have also moved in the same direction at times. Stepping back, however, this analysis is focused on shorter-term cycles in the economy where private and government spending growth goes back and forth relative to each other.
A long-term perspective at crowding effects
Taking the same figures but looking through shorter cycles, government and private sector activity indeed tends to ‘settle’ at a certain level, remaining relatively anchored to each other. The orange lines show the average growth for government and private spending for each respective period.
What could explain this longer-term pattern? A possible interpretation is that private sector growth anchors around government spending growth, thereby supporting the crowding in theory. Indeed, it is an argument currently gaining prominence.
Europe’s rethinking of its legacy economic doctrine
Germany’s recent change in fiscal tradition fits within a broader shift in Europe’s economic policy thinking that is worth taking note of.
Mario Draghi, the former President of the European Central Bank and an influential figure in this shift, argues that sustained economic growth creates the conducive pre-conditions and certainty for research and development and innovation to take place (and not only the other way around, as perhaps primarily advocated to date).
The Financial Times eloquently summarised this ongoing change in Europe’s economic policy mindset:
”Until now, the very idea that inadequate domestic demand is a root cause of EU economic sluggishness has been largely banished from the policy discussions that have mattered. Active disagreement over how to best boost domestic demand, no matter how fierce, would mean the premise that it matters had become commonplace in EU governing circles. That would be a Copernican revolution indeed.”
The Copernican revolution refers to the shift in the field of astronomy from the understanding that the earth was the centre of the universe (geocentric), to the current understanding that the sun is the centre (heliocentric). A fitting metaphor for the shifts in contemporary economic policy thinking, and the evolving assessment of the relation between government spending and private sector growth.