Government Spending and Private Sector Growth

by: Disruptive Investor

Crowding out occurs when expansionary fiscal policies cause interest rates to rise or taxes to increase, thereby reducing private spending and investment. This article attempts to analyze if the enormous U.S. government spending plan will cripple private sector growth and if the economy will perform below its potential output as a result of this government overspending.

There are several ways in which increased government spending can lead to private sector cutbacks on spending and expansion. To analyze each of these factors we need to understand how the government gets money to fund its spending programs. The alternatives for the government are few and easy to understand.

  • The government will increase taxes for individuals and corporate which will result in higher revenue for the government. The government can then fund its excess expenditure using these receipts.
  • The government can borrow money by selling government bonds. These bonds can be sold to corporate in the country or to other countries.
  • The government can monetize debt. In this case, the money is not received from any of the above two sources. Money is just printed (created out of thin air).

With the sources of funds for increased government spending clear, we now look into the impact of each on the private sector and also on the consumer in general.

Impact of Higher Taxes on Private Sector

The government might choose to raise taxes in order to fund its increased expenditures. In this case, corporations have to pay higher taxes on their profits, which will leave them with less to spend on their growth and expansion.

Higher taxes on individuals can also have a negative impact on the private sector, by causing the disposable income for the individual to fall. This in turn will impact their spending decisions. Any decline in consumption directly impacts the private sector growth.

So if the government chooses to go for higher taxes in order to fund its spending, it might be doing more harm then good to the economy in general.

Moreover, we all know how efficient the government sector is as compared to the private sector. So it would not be difficult to determine the direction of the economy of a country where the government is getting bigger and the private sector is shrinking.

Impact of Government Borrowing on the Private Sector

If the government sells its bonds to the private sector then it's sucking out liquidity from the private sector and utilizing it to fund its spending. This has a direct impact on the growth and investment plans of the private sector as they has lesser funds in place for their growth.

However, even if the government borrows funds from other countries, it impacts the growth of the private sector. The government might be able to borrow funds from abroad, but for that to work it would need to set attractive terms for bond buyers. This is especially true for a government which is already overburdened with debt. So as the emerging economies recover and inflation gets higher, these countries will demand much higher interest payments on the bonds. No one would want to buy bonds which give negative returns (when adjusted for inflation).

The U.S. government will thus be forced at one point of time to increase rates on bonds and this will lead to interest rates going up in general. Higher price for money again impacts the private sector as it might not be able to borrow funds (or borrow to the extent it needs) for its expansion.

Thus, even by selling bonds to other countries, the government might impact the private sector spending through higher interest rates. In order to keep interest rates low, the only option the government will have is to monetize debt (print money).

Impact of Debt Monetization on the Private Sector

Debt monetization is the best way to cause spiraling inflation and also accelerate the demise of any currency. Thus, debt monetization might ultimately lead to the same higher interest rates or a bigger crisis for the financial and economic system as a whole.

Does government spending only lead to negatives?

One might be wondering at this point of time that is there any positive associated with government spending and if not then whey are governments creating huge deficits which ultimately will lead to no benefit for anyone.

The answer is that government spending is not something which always spells disaster. But the following things have to be taken into consideration:

  • Where is the government spending directed? In the case of U.S, the government spending is directed towards encouraging consumption instead of encouraging capital formation and private fixed investments. The government is trying to find the solution to the problem by using the problem itself as the medicine. Thus, in my opinion, a large part of the government spending is misdirected and that will not benefit the economy in a big way. The only thing it can do is to artificially support the economy.
  • The government also needs to consider how much leverage it already has. For a country, which has record debt and deficits, it makes little sense to borrow and try to spend their way out of recession.

Private Fixed Investment Trend in U.S.
Private Fixed Investment Trend

As it is clear from the chart above, the fixed private investment has slumped in the current recession to its worst since the 1950's. This corresponds to the biggest spending spree by the government in decades.
But output gap estimates for 2009 and 2010 does not show any big positive impact of the government spending on the economy performing above its potential or anywhere near its potential.

Output Gap Estimates for 2009 and 2010
Output Gap

Thus, flooding the system with liquidity is not always the solution to the problem. It might just create even more problems.
For years there has been excessive spending in the developed world that was funded by savings in the emerging countries (as indicated by their respective trade deficits and surpluses). This trend might just change with this crisis. The Americans need to save more, consume less and also produce more. This needs more fixed investments by the private sector.
The government would do best if it allows free markets to work and create policies for a competitive private sector environment. These measures might lead to prolonged recession but help a great nation emerge out stronger from the crisis.