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Fiscal Stimulus, Interest Rates and Crowding-Out

I have an article in the Weekend Australian arguing that the government’s discretionary fiscal stimulus measures will undermine Australia’s long-run growth prospects, citing the Australian edition of a widely used undergraduate textbook:

“When the government reduces national saving by running a budget deficit, the interest rate rises and investment falls. Because investment is important for long-run economic growth, government budget deficits reduce the economy’s growth rate.” So says Joshua Gans in his Principles of Macroeconomics text. Yet Gans was also one of the 21 economists who recently signed a letter defending the government’s deficit spending.

An increase in the stock of government debt reduces the amount of capital available for private investment, although this crowding-out effect may be offset by increased private saving and foreign capital inflows. In a small and open economy such as Australia, crowding out occurs not so much because interest rates rise, but because it induces foreign capital inflows that put upward pressure on the exchange rate, lowering net exports and reducing aggregate demand, which offsets the increase in government spending.

I also have an article in Business Spectator, noting that recent market-led increases in retail borrowing rates are just a taste of things to come:

Whatever the cause of rising global bond yields, these increases in interest rates will inevitably be passed on to Australian borrowers. It would be a sign of political maturity if Australian politicians were to acknowledge this reality, rather than taking refuge in the shameless populism of bank-bashing.

UPDATE: Joshua complains about ‘selective extracting’ and an ‘unwillingness to deal with economic complexity’ in my Weekend Australian piece.  The point of highlighting the very good discussion of these issues in Joshua’s textbook was precisely to show that the 21 economists were being selective and incomplete in their analysis, by not acknowledging the many arguments against discretionary fiscal stimulus.  I would certainly encourage people to read Principles of Macroeconomics in coming to a considered view of the merits of discretionary fiscal policy.

posted on 21 June 2009 by skirchner in Economics, Fiscal Policy, Monetary Policy

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I personally am no fan of deficits. But isn’t a better indicator net borrowing. Assuming it is put to the same use, if a government’s increase in borrowing is similar in magnitude to the decrease in private borrowing, then isn’t there no net effect?

Posted by .(JavaScript must be enabled to view this email address)  on  06/22  at  01:54 AM


Domestic investment exceeds domestic saving, so Australia is a net borrower, funded by foreign capital inflows.  All else being equal, a larger budget deficit makes the public sector a larger net borrower. This may be offset to some extent by the private sector becoming less of a net borrower by increasing its saving.  So there is some substitution between public and private (dis)saving. 

But it would be wrong to assume that the government borrows for the same purposes as the private sector.  Government borrowing may change the mix between consumption and investment, as well as the composition of investment spending.  Crowding-out occurs not only though interest rate and exchange rate effects, but also through a change in the mechanism by which capital is allocated (politics rather than markets).

Posted by skirchner  on  06/22  at  03:14 AM



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