Crowding out refers to a phenomenon when increased government borrowing leads to a decline in private investment. This happens because as the government borrowing increases, it pushes up the interest rates as there is more demand for funds from the capital markets. The higher interest rates then make it more expensive for businesses and individuals to borrow money. As a result, many profitable investments that previously made sense for the private sector no longer offer decent returns. So private investment spending falls as funds get diverted towards government bonds and securities. The key reasons behind this crowding out effect are increased government deficit spending, higher interest rates, and diversion of funds towards public sector borrowing.
Increased government deficit spending is the trigger for crowding out
When the government runs large budget deficits and borrows more from the debt markets, it leaves lesser funds for the private sector to borrow. Assume the total pool of investable funds in an economy is $100 billion. Now if the government plans to borrow $40 billion to finance its expenditures, only $60 billion is left for private businesses and individuals. At higher levels of government borrowing, the interest rates are bid up as private investors have to offer higher returns to attract funds. Many projects that fetched decent returns at lower rates become unviable at the new higher interest rate regime. Consequently, private investment slows down.
Higher interest rates make investments unaffordable
As explained earlier, increased government borrowing pushes up interest rates in the economy. Consider a business that could generate 15% annual returns on a new $10 million manufacturing plant when interest rates were 5%. The business was planning to invest 40% equity capital and borrow the remaining funds. But with interest rates moving up to 8% due to crowding out, the investment math changes completely. Now the plant can only deliver 10% returns which doesn’t cover the higher cost of capital. So the business shelves the investment plan. This plays out across the economy as several other businesses also face similar issues.
Capital gets diverted from private to public sector
When the government taps the capital markets for funds, it diverts money that could have otherwise gone to the private sector. Bond investors seeking fixed income find government securities highly safe due to sovereign guarantee. So when governments launch bigger bond issuances, significant funds flow from equities and corporate debt to public sector bonds. This shrinks the pool available for funding private capex. Pension funds, insurance firms and other institutional investors too allocate more to government bonds due to safety, reducing capital availability for private enterprise.
Crowding out further slows economic growth
An economy needs robust investments by businesses to sustain GDP growth over long term. When increased public sector borrowing triggers the crowding out effect, it has an adverse impact on growth. With private investment declining, job creation and consumption slow down too. Governments need to balance welfare spending with risks of runaway deficits. A gradual glide path for fiscal consolidation ensures interest rates stay low, preserving space for private enterprise to flourish.
To conclude, crowding out refers to the phenomenon of private investment declining due to increased government spending and borrowing. As governments tap debt markets for more funds, interest rates go up making investments unviable for businesses. The diversion of capital towards public sector securities is another key reason behind this effect. Managing fiscal deficits prudently is crucial to prevent crowding out so that private enterprise can thrive.