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Finding Religion on “Crowding Out”

Here’s Paul Krugman on a recent IMF report which says that government deficits don’t necessarily “crowd out” private investment:

The false belief is that government deficits necessarily “crowd out” investment, so that reducing deficits should free up funds that lead to higher investment. Not so, says the IMF: when governments introduce deficit-reduction measures, investment falls instead of rising. This says that the deficits were crowding investment in, not out.

And here’s Paul Krugman back in 2009 on this matter:

“Crowding out: when it runs deficits, the government competes with the private sector for funds, so deficits crowd out private investment, which reduces potential growth

All this makes sense under normal conditions. But right now we’re not living under normal conditions.”

Except, that doesn’t make sense even in normal conditions. Back in 2009 Dr. Krugman was using a loanable funds model of the world with a fixed money supply. And he was still using that model back in 2012 when he incorrectly (according to monetary cranks like myself and that Central Bank in England) said banks can’t create money from thin air:

“First of all, any individual bank does, in fact, have to lend out the money it receives in deposits. Bank loan officers can’t just issue checks out of thin air”

But what was once a temporary “liquidity trap” is now being extended into some sort of permanent liquidity trap. And the problem is that we’re not realizing that the model was actually never quite right even if it made some decent predictions. The government’s deficit does not necessarily “crowd out” private investment in “normal times” because the government does not compete to borrow in some fixed market for loanable funds. As I’ve stated on numerous occasions, this isn’t some temporary “zero lower bound” environment. It is always true, in a world of endogenous money, that the government doesn’t compete for some fixed money supply.  But here we are 7 years removed from the crisis pretending that a temporary environment has now become permanent. No, all the crisis did was expose some realities for what they were: the money multiplier is wrong; government deficits don’t drive up interest rates; Central Bank “money printing” doesn’t cause high inflation; government deficits don’t necessarily “crowd out” private investment.  These realities aren’t necessarily unique to this environment or some theory about “liquidity traps”.

Why does any of this matter? Well:

  1. It’s operationally wrong. We shouldn’t use economic models of the world that are based on falsehoods.
  2. Policies and understandings are being influenced based on such prominent thinking. This means falsehoods are being propagated and influencing social impact.
  3. The “temporary” argument feeds into the thinking that, if tax cuts and deficit spending are only temporary aids, then that means we have to unwind it all later which leads many to say “well, why trade good now for bad later?”

And all of that is hurting the economy and not helping it.

NB – The primary point here is that we should make a distinction between “financial crowding out” and “non-financial crowding out”. After all, in a world of endogenous money the government doesn’t necessarily compete for financial assets, however, it does compete for non-financial assets like real resources.