Crowding Out: The Accounting Error That Rules the World
How a fundamental misunderstanding of government deficits fuels austerity and costs lives
What you will learn:
Why the ‘crowding out’ story is based on faulty assumptions; how deficits and surpluses really work; why banks do not lend from a fixed pool of savings; what government bond sales actually do; why deficits add to private sector savings; and why public investment tends to crowd in private sector investment rather than crowd it out. Keywords: Crowding Out, Macroeconomics, Economics.
Dangerous Misunderstandings, Economic Myths, and the ‘Crowding Out’ Story
In Warren Mosler’s ‘Seven Deadly Innocent Frauds’ he recounts conversations he had with former Assistant Treasury Secretary Lawrence Summers, Vice President Al Gore and former U.S. Treasury Secretary Robert Rubin that demonstrated that they had little understanding of how government deficits or surpluses work.
That is, they did not understand the effects of deficits or surpluses on the health of the economy and the people who live and work in it.
For example, here is Assistant U.S. Treasury Secretary Lawrence Summers replying to Mosler’s question on why a deficit is a problem:
“It takes away savings that could be used for investment.”
And here is Robert Rubin, former U.S. Treasury Secretary on his understanding of the impact of running a surplus on the non-government sector:
“When the government runs a surplus, it buys Treasury securities in the market, and that adds to savings and investment.”
Both of these statements are 100% wrong; in fact, they are the opposite of reality.
However, their misunderstanding is no surprise; it is a reflection of the mainstream view, as taught within many macroeconomics textbooks.
For example, in Macroeconomics by N. Gregory Mankiw, considered a leading textbook for intermediate macroeconomics, we find the following:
“Because the increase in government purchases is not accompanied by an increase in taxes, the government finances the additional spending by borrowing—that is, by reducing public saving. With private saving unchanged, this government borrowing reduces national saving”(p. 72)
This idea is called, ‘crowding out’. That is, private sector investment is crowded out by government borrowing.
It is based on the following ‘logic’. If the government spends more than it takes in in taxes, it has to borrow from the private sector, and that borrowing reduces available investment funds, as there is a finite amount of savings ‘to go round’.
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What’s wrong with the crowding out story?
There are several problems with this story.
Firstly, there is no finite amount of funds to borrow from. Banks do not lend from existing funds when creating loans. In practice, when they give a loan, they simply write numbers into customer accounts, subject to regulatory constraints and their own assessments of risk and profitability.
And secondly, currency issuing governments do not borrow from the private sector. When they ‘sells bonds’, those bonds are swapped for the same value in reserves. Commercial banks, with central bank reserve accounts, swap the reserves they hold in one account for bonds of the same value they now hold in another account. The government has borrowed nothing as part of this process.
Why is the crowding out story dangerous?
The crowding out idea becomes dangerous when combined with the equally erroneous belief (for currency issuing governments) that government ‘debt’ must be reduced. It’s dangerous because it acts as a catalyst for misguided government policy.
By that I specifically mean austerity policies i.e. cuts in government spending or tax rises that leads to degradation of public infrastructure (roads, bridges, public buildings) and cutbacks in services such as health, education and welfare; which also cause a loss of public sector jobs.
Such cuts result in less money in household and business accounts; meaning people spend less and firms have less revenue to invest or hire. With less demand for products and services, businesses lay off workers, leading to even less demand and even more cutbacks.
So, it’s no surprise to find historic evidence showing that austerity policies - when they result in a net loss in savings within the private sector - lead to economic downturns.
Mosler points out in his ‘Seven Deadly Innocent Frauds’ book, ‘the last six periods of surplus in our more than two hundred-year history had been followed by the only six depressions in our history.’ (P. 47)
And it’s not just about living standards, research shows that austerity is connected to lives being lost. A Glasgow University study in 2022 concluded that,
“Over 300,000 ‘excess’ deaths in Great Britain attributed to UK Government austerity policies” Glasgow Centre for Population Health (GCPH) and the University of Glasgow
The truth is, deficit spending does not remove investment opportunities from the private sector, it adds them. Orthodox economists and governments have it the wrong way round.
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How deficits and surpluses really work
“Simply put, government deficits ADD to our savings (to the penny). This is an accounting fact, not theory or philosophy. There is no dispute. It is basic national income accounting.” The Seven Deadly Innocent Frauds by Warren Mosler (p. 44)
Deficits and surpluses are simply accounting outcomes; if the government spends £100 into the economy but collects £80 back in taxes, that means £20 has been left in the non-government sector.
That extra £20 shows up as income and savings across households and businesses; they are now £20 better off in aggregate: with more money and financial assets than before.
Of course, when the government runs a surplus, the opposite happens.
Taking a sectoral balances approach reveals the true story:
Economist Wynne Godley showed that the government’s balance and the non-government sector’s balance are linked:
A government deficit is, by definition, a surplus for the non-government sector, and, of course, a surplus is the opposite.
This simple, but seemingly hard to grasp, approach is called the sectoral balances approach.
What does this mean in practice? Well, the kicker is this: once it is understood that currency issuing governments cannot run out of the one thing they issue themselves - and that the real constraint on spending is the availability of resources - deficit spending should (must) be understood in an entirely different way.
That is, the right amount of government spending, whether it be a deficit or a surplus, has nothing to do with the deficit figure; it has everything to do with the government’s goals and the available resources to meet those goals.
The size of the deficit or surplus is of little interest as a figure in itself - it is simply an outcome of the government meeting its goals within the available resource constraints.
Equally, the crowding out argument is irrelevant, as it is based on faulty assumptions about how the banking system works and the nature of ‘debt’ for currency issuing governments.
In Conclusion: the orthodox economists’ ‘crowding out’ story is wrong and it is dangerous
The orthodox crowding out idea doesn’t just misunderstand accounting relationships, it negatively impacts lives, weakens infrastructure and increases economic instability. The crowding out story is indeed dangerous - to our health and the health of the economy.
With a better understanding of commercial banking, government debt management, and the nature of deficits and surpluses, politicians’ thoughts shift away from their irrational fixation on numbers to a focus on real outcomes.
By real outcomes I mean ensuring everyone who wants a job can have one; adequate investment can be put into public services and the government can invest in ensuring long-term prosperity - within real resource limits.
Contrary to the orthodox crowding out story, the truth is that government investment ‘crowds in’ private sector investment. It puts money into the economy and that creates greater demand - which in turn creates opportunities for businesses to produce more, hire more, and invest more in new projects.
That’s all for now.
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Resources
Seven Deadly Innocent Frauds of Economic Policy - Warren Mosler
Glasgow Centre for Population Health (GCPH) and the University of Glasgow
Macroeconomics by N. Gregory Mankiw
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My MMT Top Ten: Modern Monetary Theory’s Best Ideas Explained
Important Figures in the Development of MMT: Abba P. Lerner ‘Functional Finance’ - Jim Byrne
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At some point, this just comes down to willful ignorance. And especially those that are ignorant keep bringing up the Clinton surpluses of the 90's having zero awareness of the damage it did to the private sector long term. The notion that gov budgets must balance or operate like a household is literally killing us. It's no accident as to why we are lacking the necessary investments needed in our economy (falling behind China via solar & clean energy) simply because the majority of Americans have misunderstood the word "debt". It's just numbers on a spreadsheet, the focus should not be on the lack of dollars but the real resources & not to mention there are limits to spending mainly in the form of inflation. I would encourage those to read The Deficit Myth by author Stephanie Kelton.
The Glasgow study was 2022, not 2002, by clicking on your link.
We discussed this last time this came up, but, again, lest your readers misunderstand: this represents an absolute decline in deaths since 2010, a year with, until then, the lowest mortality in forty-seven years or more. While the real and very sharp turn in the trend line from 2010 onwards makes for a solid comparison with the start of Austerity, this also makes for a good illustration of the possibilities for abuse inherent in the excess deaths statistic.
UK death rate at 'record low' returning to pre-pandemic levels | News UK | Metro News https://share.google/JNyrCqHIFfzs1TmHc
Warran Mosler (p. 44) misspelled