Arnold Kling  

Crowding Out: A New Subject

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Menzie Chinn writes,


It appears to me that real interest rates were undeniably higher during the Reagan administration than during, say, the past four quarters of the Obama administration

I see that we have managed to change the topic from "liquidity trap" to "crowding out."

I don't recall where I raised the topic of crowding out. Crowding out, for those of you who are new to this stuff, is when government deficit spending raises interest rates and thereby reduces private investment.

There are at least three Keynesian arguments against the existence of crowding out.

1. Excess capacity in the economy. A flat aggregate supply curve, in textbook-speak. With excess capacity, the economy can produce output for government stimulus and still have plenty to spare to produce capital goods for business investment.

2. Inelasticity of spending with respect to interest rates. A vertical IS curve, in textbook-speak. That is, consumers and businesses do not care much about interest rates when they make decisions about buying houses, cars, or capital equipment. Instead, they care mostly about their income, wealth, and profits.

3. Nominal interest rates are stuck. A flat LM curve, in textbook-speak. The infamous liquidity trap, in which no matter how much borrowing comes from the private sector and government, the interest rate stays the same.

I don't buy (3) at all. I tend to doubt (2), but I could be persuaded. I think that (1) is likely to be true. I am not a believer in crowding out in a deep recession.

My problem with fiscal stimulus is that I believe we need permanent adjustment to new sustainable patterns of trade, not temporary moves. I think that if you want to eliminate unemployment in a meaningful way, you have to know something about where people ought to be employed, and Washington does not have that information. It is not that I expect deficits to crowd out other economic activity. I don't think they will create any real economic activity to begin with. But those are my own crackpot views, and if you dispute them you're probably right.


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CATEGORIES: Macroeconomics



COMMENTS (5 to date)
honeyoak writes:

I am not as certain as you are Arnold about #1. there is the most microeconomic empirical for #2 though how big a part of the story it is remains an open question. "excess capacity" to me sounds an awful lot like a "liquidity trap", a perpetually changing unfalsifiable statement. it is not obvious at what margin there is excess capacity and how one would realistically aggregate such a measure. perhaps one could use changes in the depreciation rates of capital but then one would have endogeneity issues. it is really hard to estimate how cheap it really is to procure government goods (as opposed to other actions such as borrowing) given that the government rarely faces competitive prices for its procurement ( with the notable exception of the labour market) nor does it maximize given some budget constraint (political markets work very differently).

on a side note I always thought that crowding out regarded the allocation of credit rather than the interest rate per say.

Usems writes:

I was unconvinced of crowding out until a grad school professor redefined it for me. He explained that it is much easier to understand it in terms of opportunity cost. If the government borrows, it must have come from someone. What would that individual/entity have done with the money had he not lent that money to the government? That activity, whatever it was, was crowded out by government borrowing. Since that borrowing comes from countless economic actors, in reality we have no idea exactly what activities were crowded out.

Perhaps this is changing the focus from interest rates to opportunity costs, but it was the most straightforward succinct explanation I had heard, and it came from an otherwise avowed Keynesian no less! Of course, this explanation gets far more complicated once you involve the impact on exchange rates by foreign lenders and the Fed printing money, but at least it offered a straightforward logical starting place to start from.

JCE writes:

"My problem with fiscal stimulus is that I believe we need permanent adjustment to new sustainable patterns of trade, not temporary moves."

I agree. But Arnold, help me out here. Suppose, just for the sake of argument, that Washington COULD get the information required to spend on a sustainable pattern of trade. that spending wouldn´t necessaryu crowd out private spending, right?
I mean the argument for crowding out doesn´t 'discriminate' between types of spending, right?
In a credit economy, if I borrow money to spend that doesn't mean someone else can´t also spend THE SAME MONEY, right?

John V writes:

"Suppose, just for the sake of argument, that Washington COULD get the information required to spend on a sustainable pattern of trade. that spending wouldn´t necessaryu crowd out private spending, right?"

Sure. But the hypothetical involves taking an impossibility as possible and probable. So what's the point?

That's like saying "suppose, for the sake of argument, people could fly..." and then drawing a possible conclusion from it. What's the point?

Steve Roth writes:

I was also disappointed with Krugman's (non-)response/semi-change of subject. I'm thinking the linkage was clear in his head, but...

On the earlier topic, I find the following to display rather clear thinking, though I am personally unclear on whether I agree with the conclusions:

http://practicalstockinvesting.com/2010/10/18/liquidity-trap-what-is-is-are-we-in-one/

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