Monday, February 14, 2011

"Crowding Out" - How will the United States federal debt affect the corporate economy?

Updated to July 26th, 2011

It's really quite amazing the documents that can be found on various government websites.  One of my favourite websites is the Congressional Budget Office or CBO.  The CBO is a federal agency that operates within the legislative branch of the government.  It is a non-partisan agency whose primary purpose is to provide data regarding the economy to Congress and to assist them with estimates of both revenue and spending.  I thought that this posting was particularly timely since the White House is now in the midst of rather childish negotiations over the proposed increases to the debt ceiling.  Any additional debt will require the Treasury to go back with their hat in hand to the world's bond markets to raise funds to cover their overspending.

Here's a document that I've referred to in past postings.  In June 2010, the CBO released its Long-Term Budget Outlook, a detailed examination and projection of the revenue and spending scenarios for the next several decades.  What I really like about this document, in particular, has absolutely nothing to do with its accuracy because we all know that economic projections are barely worth the paper that they are written on (unless, of course, it's toilet paper).  I like it because it shows that at least someone in government is thinking well beyond the election cycle.  The tendency of our elected officials is to work on a 2 or 4 year cycle rather than thinking in generational terms.  This is what has caused fiscal problems for so many governments around the world, most particularly, the United States, the United Kingdom, Canada, Japan and the PIGGS nations.  When government only thinks short-term, the repercussions of over-spending and under-revenuing never seem to come home to roost.  The problems are for the next government to deal with and so on ad infinitum.

One interesting aspect of the economy covered in this paper is what the CBO terms as "crowding out".  From mainstream media and government reports, we are all aware of the mounting debt and deficit issues facing the United States.  In the first 9 months of fiscal 2011 alone, the federal government has had to cover an additional $973 billion shortfall.  This means that the Treasury Department has to raise the funds somewhere, so it issues additional bonds to willing purchasers including China and Japan among others.  

Here is a look at the Monthly Statement of the Public Debt of the United States on January 31st, 2011 just so you have an idea of the overall debt situation:

Crowding out refers to the situation where increases in government borrowing crowds out non-government (i.e. private or corporate) investment in capital which leads to lower overall economic output.  Simply put, if you have $100 to invest and you pick government bonds over corporate bonds, that money is not available to the non-government or private sector for them to invest in new equipment or plants.  The only exception to this is when the government borrows to finance items like infrastructure improvements (highways, airports, bridges, mass transit) as long as the government investment is as productive (i.e. adds as much value to the economy) as private sector investment.  In the case of government expenditures that add to the debt today, most of these are related to what are termed "entitlement programs" such as health care and Social Security.

Another impact of crowding out is that it can impact the savings rate of individuals.  Since additional borrowing by government often (or ultimately) results in higher interest rates, individuals may be more prone to save their money.  If interest rates are high enough, individuals will invest those savings in either government debt or private debt depending on their preferences.  This can to some degree mitigate the effect of crowding out, however, as was shown in the initial stages of the Great Recession of 2008 - 2009, investors fled en masse to the perceived security of government bonds resulting in near zero interest rates on Treasuries.  At the same time, because there was so little demand for corporate bonds that were perceived as risky that their yields were pushed up to double digits.  In large part, the crowding out of corporate bonds exacerbated the Great Recession because corporations were unable to raise funds to spend on capital equipment because they were deemed overly risky by investors.

The CBO concludes that greater government borrowing (debt), in general, leads to lower national savings which ultimately results in lower domestic investment.  Higher interest rates may, however, attract more foreign capital to the United States preventing a steep decline in overall investment.  The downside to attracting more foreign investment results from the rising obligation to send a larger portion of GDP in the form of profits and interest payments to those overseas investors meaning that U.S. residents do not benefit as much from the additional investment as they would if the investment had come from Americans.  Basically, if U.S. corporations are "owned" (i.e. their debt is owned) by overseas investors, both the interest payments on the debt and profits from the private sector get "shipped" overseas rather than staying in America where they benefit the domestic economy.

In their analysis, the CBO assumes that crowding out reduces tax revenue because GDP is reduced.  This results in even greater federal debt which further raises interest rates which results in even greater federal borrowing which creates even greater crowding out.  It's an endless upward (or downward), self-perpetuating spiral.  The CBO is not just pulling these projections out of thin air; they are based on past experiences with federal debt and crowding out. 

Here's a chart showing the drop in GDP from the dark blue line (where there has been no crowding out) to the dark blue dashed line (where there has been crowding out):

From this chart, you can see that there is a great danger from crowding out.  With these projections and experiences from past events, the CBO estimates that real GDP per person under the "alternative fiscal scenario" (as outlined here) would be 6 percent lower in 2025 and 15 percent lower in 2035 than if no crowding out existed (i.e. if no additional debt were accrued).  

Another great danger lies in the fact that, because GDP declines due to the crowding out effect, the debt as a percentage of GDP increases more than would be expected if there was no crowding out.  This is the measure used by most economists to determine the fiscal health of a debtor nation.  Here's a chart showing the changing debt as a percentage of GDP under the scenario where there is no crowding out (solid) and the scenario where there is crowding out (dashed line):

Notice how by 2030, the debt to GDP level rises to 140 percent of GDP if there is no crowding out but rises even more steeply to an astronomical 200 percent of GDP if crowding out is present.

Yet another issue arises with the funding of growing deficits and debt.  A portion of the federal government debt is held by foreign nations.  The foreign holders of that debt expect to receive regular interest payments (basically, a portion of your tax dollars).  When the interest payments on the debt  are made to non-American bondholders, that money is no longer available to American households unless the bondholder chooses to re-invest in the United States.  As the debt rises, an increasing portion of GDP is used to make those interest payments.  Right now, roughly 1 percent of GDP goes to debt payments.  This is anticipated to rise to 4 percent of GDP by 2035 in the best case economic scenario and about 9 percent of GDP in the worst case.

Once again, we can see the great dangers to the economy from federal government over-indebtedness.  The fickle fingers of fiscal mismanagement on the part of our elected officials will reach deeply into the economy, impacting all Americans at home and on the job.


Congressional Budget Office - The Long-Term Budget Outlook - June 2010 (revised August 2010)


  1. There is no "crowding out". The money to buy government debt comes from government spending.

    The "crowding out" theory assumes that there is some fixed supply of "loanable funds" which borrowers compete for. This is false in both the private and public cases; loans create deposits, not the other way around. The only limit on the making of loans is the capital of banks and the creditworthiness of borrowers.

    Here's a brief explanation:

  2. I would say this is not currently an issue. Remember the United States is monetizing their debt (asmuch as they like to claim otherwise). The Federal Reserve is 'printing' reserve notes to buy those treasury bonds, so the money to fund this debt is being created as needed, for the time being anyway. Though this may become an issue when the inevitable debt-rollover time comes; remember the US never actually pays it's debt off, it simply issues new debt (basically a perpetual refinancing).

  3. Anonymous wrote:
    The US never actually pays its debt off; it simply issues new debt (basically a perpetual refinancing).
    You're right, except in times of budget surplus.
    This refinancing works like a retirement plan in reverse, with compounding interest.
    Do you think the government's lack of concern about inceasing principal and intererst has some impact on Americans' concerns about their levels of debt?
    It seems like debt is okay, almost like it actually represents an asset.
    Also, if the U.S. is unable or unwilling to pay off its debt, or even start to, will that effect the full faith and credit of the U.S. Government/
    A debtor who pays only interest all these years, would, in my mind, appear to be insolvent.
    Don Levit

  4. How can a country that prints it's own money ever have a debt crises? You just print more money. There is much more at play here.

  5. And, eventually, after printing enough money, you end up with hyperinflation as in the case of the Weimar Republic or modern day Zimbabwe!