Strategic Briefing | 3.4.2011 | The Crowding Out Effect On Interest Rates

The theory of “crowding out” predicts that higher government borrowing may force interest rates higher than they otherwise would if the private sector prevailed in the money markets. How does this theory jibe with recent history? Read on for some perspective…
Crowding Out Watch, Updated
Menzie Chinn, Econobrowser | Mar 1
I’m teaching the concept of portfolio crowding out in my intermediate macro course (handout with algebra here) now, and as I was going through the notes, I observed that last I had checked, there was (still!) little evidence of crowding out… Relative to my September post, the ten year TIPS is slightly up, but the five year remains at zero (well, actually negative). This means that whatever upward pressure there is on government interest rates due to the large supply of government debt, it is being offset by low demand from the private sector (or by demand from offshore sources).
A Federal Shutdown Could Derail the Recovery
Mark Zandi, Moody’s Analytics | Feb 28
While the government spending cuts proposed by House Republicans for this fiscal year mean only modest fiscal restraint, this restraint is meaningful. If fully adopted, the cuts would shave almost 0.5% from real GDP growth in 2011 and another 0.2% in 2012. This wouldn’t be true if the current budget deficits were crowding out private investment, but they aren’t. Business demand for credit has recovered modestly, and households continue to lower their debt obligations. Interest rates also remain extraordinarily low. Some of this is due to the Fed’s credit easing, but global investors also remain willing buyers of U.S. debt even at low interest rates.

Dollar for Dollar Crowding Out in the Textbook Keynesian Cross Model When the Economy is Below Full Employment
Sheldon Stein, Cleveland State University | Jan 15, 2010
We cannot have full employment without more national savings and we cannot have more national savings without having full employment.
Economist Argues The Deficit Isn’t Issue No. 1
Dean Baker, Center for Economic and Policy Research | Feb 28
The reason why we should be concerned about a deficit is it’s crowding out private-sector spending, private-sector investment. You’re really hard-pressed to tell that story right now. We still have extraordinarily low interest rates. We have excess capacity in just about every sector of the economy. You’d be very hard-pressed to say how let’s say the government were to spend another three or $400 billion this year. How would that crowd any substantial amount of private-sector investment? You’d be very hard-pressed to say that.
Spend or cut: US economists split on best medicine
AFP | Mar 3
Washington politicians seeking support in their bitter budget battle aren’t getting much help from economists, who are divided over whether spending is the best medicine for the struggling economy. Democrats have recruited a phalanx of economic stars to support their fight against some $61 billion in cuts Republicans are trying to force on the White House. Democrats say such cuts will cost hundreds of thousands of potential jobs this year, at a time when the unemployment rate languishes at nine percent. But Republicans are answering with their own heavyweights, who insist that more government spending — and the mounting deficits that come with it — hurts job creation and endangers the economy over the long run…The White House’s opponents largely reject the Keynesian model embraced by many economists, which holds that government spending can jump-start an economy in a depressed, low-inflation situation.
“There’s no scientific consensus on that model,” argued Adam Gifford, chairman of the economics department at California State University — Northridge, who signed the letter backing budget cuts. [Stanford University economics professor John ] Taylor says his own economic models show, in contrast to the Keynesian view, that in a supposed competition for funds, government spending crowds out the private sector. “A reduction in the growth of spending will immediately ‘crowd in’ private investment,” he said. But Gifford was less certain on that point. “With the low real interest rates, it’s hard to make a case that there is real crowding out of the private sector right now,” he said.
Fiscal Positions and Government Bond Yields in OECD Countries
Joseph Gruber and Steven B. Kamin, Federal Reserve | Jan 5, 2011
Using a large panel dataset of OECD countries, we have identified a robust and significant impact of fiscal performance on long-term bond yields. Based on our estimates, by 2015, yields could be 60 basis points higher in the United States than would have been the case in the absence of the projected increases in debts and deficits since the advent of the financial crisis. Excluding Japan, whose bond yields are not well-explained by our model, bond yields in other G7 countries would be up by lesser amounts. All told, these estimates point to a material, but not overwhelmingly large, impact of the global fiscal deterioration on bond yields…
Our econometric results provide no evidence for the view that concerns about inflationary effects underlie the linkage between fiscal deficits and bond yields: we identify such a linkage even controlling for projected inflation; removing projected inflation as an explanatory variable does not affect our estimation results; and there is little evidence of a direct effect of fiscal performance on inflation expectations in our sample.
Does Government Debt Crowd Out Investment?
Nora Traum, Indiana University Bloomington and Shu-Chun Yang, CBO | Apr, 2010
We estimate the crowding-out effects of government debt for the U.S. economy using a New Keynesian model with a detailed fiscal specification. The estimation accounts for the interaction between monetary and fiscal policies. Whether private investment is crowded in or out in the short term depends on the fiscal or monetary shock that triggers debt expansion. Contrary to the conventional view of crowding out, no systematic relationship among debt, the real interest rate, and investment exists. At longer horizons, distortionary financing is important for the negative investment response to a debt expansion.