Crowding out is an idea often used by fiscal conservatives to suggest that a strategy of using fiscal policy to stimulate demand during an economic recession might not be particularly effective.

What is crowding out?

The essence of the crowding-out argument is as follows:

Expectations of higher taxes: For instance, if a government reduces direct and/or indirect taxes today, households expect future taxes to rise to pay for the higher budget deficits, thus, people will choose to save more leaving aggregate demand unchanged.

Higher interest rates: A partial crowding out of private consumption by government expenditure can also occur through the effect that increased public borrowing has on rising interest rates – especially in countries with high levels of debt. When borrowing is high the price of bonds may fall driving the yield on a bond upwards. Interest rates such as mortgage rates and the cost of corporate bonds tend to take their cue from what is happening to interest rates on government bonds. The higher interest rates then lead consumers to postpone part of their planned consumption.

Most of the evidence that we have suggests that crowding-out is unlikely to be 100% and that fiscal policy does have a role to play in stimulating domestic demand. Consumers often look back at what happened to their incomes last year rather than looking forward to what they expect to happen to their tax bills. Secondly lower-income consumers many of whom have few if any savings tend to spend a high share of any boost to their disposable income when taxes fall - they have a high marginal propensity to spend. This hints that targeted fiscal measures such as tax cuts for lower income groups or infrastructure spending that boosts employment in industries where wages are relatively low can have a significant impact on demand.

If crowding out is not a major problem - fiscal policy can play an important counter-cyclical role “leaning against the wind” of the economic cycle.

Given that the global fiscal stimulus already announced by the G20 countries amounts to something approaching 2% of world GDP - we will see in 2009 and 2010 just how strong is the fiscal impulse given to global demand during the economic and financial crisis.

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