Feb 14 2009
Will the stimulus package “crowd-out” private investment and reduce long-run growth potential in America?
Published by Jason Welker at 4:48 am under
Technorati
Flickr
del.icio.us
Ice Rocket
WikipediaCBO Director’s Blog » Macroeconomic Effects of the Senate Stimulus Legislation
The February 9th edition of the excellent NPR show, Planet Money reported on a letter sent from the director of the Congressional Budget Office to the Senate, forecasting the short-run and long-run macroeconomic effects of the House Stimulus Package.
It turns out the director of the CBO has his own blog on which he published his letter to the Senate. Here are some highlights:
CBO estimates that the Senate legislation would raise output by between 1.4 percent and 4.1 percent by the fourth quarter of 2009; by between 1.2 percent and 3.6 percent by the fourth quarter of 2010; and by between 0.4 percent and 1.2 percent by the fourth quarter of 2011. CBO estimates that the legislation would raise employment by 0.9 million to 2.5 million at the end of 2009; 1.3 million to 3.9 million at the end of 2010; and 0.6 million to 1.9 million at the end of 2011…
Most of the budgetary effects of the Senate legislation would occur over the next few years. Even if the fiscal stimulus persisted, however, the short-run effects on output that operate by increasing demand for goods and services would eventually fade away. In the long run, the economy produces close to its potential output on average, and that potential level is determined by the stock of productive capital, the supply of labor, and productivity. Short-run stimulative policies can affect long-run output by influencing those three factors, although such effects would generally be smaller than the short-run impact of those policies on demand.
In contrast to its positive near-term macroeconomic effects, the Senate legislation would reduce output slightly in the long run, CBO estimates, as would other similar proposals. The principal channel for this effect is that the legislation would result in an increase in government debt. To the extent that people hold their wealth in the form of government bonds rather than in a form that can be used to finance private investment, the increased government debt would tend to “crowd out” private investment—thus reducing the stock of private capital and the long-term potential output of the economy.
The negative effect of crowding out could be offset somewhat by a positive long-term effect on the economy of some provisions—such as funding for infrastructure spending, education programs, and investment incentives, which might increase economic output in the long run. CBO estimated that such provisions account for roughly one-quarter of the legislation’s budgetary cost. Including the effects of both crowding out of private investment (which would reduce output in the long run) and possibly productive government investment (which could increase output), CBO estimates that by 2019 the Senate legislation would reduce GDP by 0.1 percent to 0.3 percent on net.
The fascinating thing about this letter from the Congressional Budget Office to the Senate is that it mentions so many of the Macroeconomic principles we teach in both AP and IB Economics.
- The nation’s potential output (PPC) is “determined by the stock of productive capital, the supply of labor, and productivity”.
- Fiscal stimulus’ effects, while possibly significant in the short-run, may result in less long-run growth due to “crowding-out” of private investment as the public puts its savings into government debt and takes it out of the market for loanable funds.
- A stimulus package should be made up of “funding for infrastructure spending, education programs, and investment incentives, which might increase economic output in the long run.” The negative effects of crowding-out could be offset through responsible government spending.
I find this letter to be surprisingly positive. The short-run forecast seems optimistic: as much as 3.6% GDP growth and as many as 3.9 million new jobs by the end of 2010. The negative growth effects of the stimulus resulting from increased government debt and the subsequent “crowding-out” of private investment are not predicted to set in until 2019.
I always tell my students that humans are “short-run creatures living in a long-run world”. I have to admit, this short-run creature is inclined to think that a stimulus package that puts nearly 4 million people to work and turns the US Economy back onto a path towards growth within two years is probably worth the long-run risk of sluggish growth ten years down the road due to the decline in private investment resulting from the debt-financed spending today.
This letter from the CBO also seems to address a debate recently undertaken in the AP Economics teacher email list: whether deficit-financed government spending affects the supply of or the demand for loanable funds in the economy.
To the extent that people hold their wealth in the form of government bonds rather than in a form that can be used to finance private investment, the increased government debt would tend to “crowd out” private investment—thus reducing the stock of private capital and the long-term potential output of the economy.
This passage from the director’s letter indicates that it is the supply, not the demand for loanable funds that shifts, driving up real interest rates in the economy. Savers will take their money out of banks and other lending institutions and put it in government bonds, reducing the amount of capital available for private investment. This can be illustrated as a leftward shift of the supply of loanable funds.
Discussion questions:
- In evaluating the use of expansionary fiscal policy, we learn in IB Economics that the crowding-out of private investment will reduce the expansionary effect of increased government spending. Is crowding-out a problem during a recession? Why or why not?
- Discuss the following statement: “In order to finance its budget deficit, the US government must borrow from the private sector.” How does the government borrow from the American people?
- Will fiscal stimulus in the short-run lead to increased growth or decreased growth in the long-run? Discuss.
About the author: Jason Welker is a teacher at Zurich International School in Switzerland, where he teaches Advanced Placement and International Baccalaureate Economics. Jason was an international school student in Malaysia before studying economics at Seattle University then earning his Masters in Education. He calls Seattle and Northern Idaho home. In addition to maintaining an economics wiki and this blog for economics student and educators, Jason also gives presentations on using Web 2.0 tools in education at workshops and conferences around the world. His economics wiki won the 2007 "Best Educational Wiki" award from the "EduBlog Awards". Related posts:
- Fiscal Stimulus package passes in Congress – here comes $170 billion, America!
- How big is the government spending multiplier in America? Well, it depends on which economist you ask…
- From the Help Desk: Long-run vs. short-run economic growth, consupmtion and investment…
- Supply – side economists: “lower taxes, more growth, more tax revenue!”
- A must read for AP Macro teachers: Paul Krugman explains why deficit spending during a recession does NOT cause crowding-out
Teachers!
Submit your Econ questions here. Replies will be posted to the blog
This whole crowding out effect does see to be a move in a bad direction, but in the situation the economy is is right now, i think it is a smaller price to pay than the alternative. You can argue that this stimulus may be short sited, but when keyensian policy is used, every move is short sited; I understand that few keyensian changes may harm the long run with the crowding out effect, in this situation, the short run gain is worth the long run pain.
This article gives off the impression that the “crowding-out effect” is only minimal, and would be easily off set by a good choice of government spending. I would argue for the stimulus package, as the economy needs to be fixed now, and minimal decreases in output in future are worth it. Like the article says, people are “short-term creatures.”
It is important that the government spends money now to get the economy out of the current recession, before it gets worse than necessary. The risk of having -0.1 to -0.3% GDP growth in the future is negligible in comparison to the prospect of having 3.9% growth by 2010. In my oppinion, the short run effects outweigh the long run effects.
I would say the stimulus package is needed even if in the long run the GDP will decrease by a small amount of 0.3%. By 2010 the economy will increase as much as 3.6% GDP growth and as many as 3.9 million new jobs. We can worry about the increased government debt and the subsequent “crowding-out” of private investment in 2019 when we get there but, in the short term, we can fix the economy for now.
Deficit spending will reduce investment as the graph shows, this is because the government effectively takes money away from the firms and households. However the Government is planing to to pump this money back into the economy. The question is should the money be distributed by the firms or the government. In a free market economy it must be argued that the money is in better hands with the firms. But the main reason we are in this credit crisis is due the over investment and greed of multinational corporations. I feel we are in a situation where we actually do not actually know best where our money should lie, and this is why I would personally prefer the money to be in the hands of the Government as I feel that they actually have a sustainable plan for the next 5 years. I would be afraid that if the money were again to go to the firms it would be invested poorly again or just simply used to pay overdue bonuses.
Like the guys above, I think the stimulus package is needed, even though there would be a decrease in GDP in the future. There will be a 0.1% ~ 0.3% decrease in the long-run GDP but I personally think that is much better than a huge increase in unemployment in the short-run. In a situation we’re having, the short-run gain is definitely more desirable.
I agree to all your points and yes the stimulus package is needed because in the short run the government deficit spending will lead to a quick gain for the economy. Yes the GDP would go down but it is still more benefitial for the economy. Furthermore it doesn’t seem like such a bad thing if “investors would take their money out of banks and buy bonds” because they would pump even more money into the society making it possible for the economy to recover even faster.
In order to evaluate the validity of the stimulus package we need to weigh up the long/short outcomes and the benefit and drawbacks of it. One of the most important questions we have to address is: what is the opportunity cost addressed to not implementing the stimulus package. No matter what the economy does, it will need to borrow money from the loan able funds market. The US interest rates cannot be lowered any further as it is already at .5%, the only other possible stimulus program available to the government would be a supply side policy, such as deregulation and abolition of minimum wage. I believe the crowding out that would occur as a result of the stimulus package would be a small price to pay in order to repair the current economic situation.
Our economy is today so bad that many things seem to be either helpless or not worth trying but looking at the the so called crowding out effect it seems go into a even worst direction. So even if the economy could get a little sorted and look better there would still be a lack of money. this money needs to be borrowd from somewhere else. There is a few places this money could come from the loans able funds market. and the intrested rates need to go up they are to low right now. if that would happen the next step would be looking at the maximum income and minimum income and then adapt the tax system to these numbers.
Though the ideas of having a better GDP and lower unemployment seem to be the answer at this time, I don’t think it’s actually one of the wiser ways to go about our economic situation. I see what this would mean to our generation, but wouldn’t it all just be another way of putting up a front to seem like we’re having a better economy when really all we’re doing is pushing the problem back a few years? Basically, the facts here state that by taking this route, we’re saying that people can spend more money, meanwhile private investment is depreciating in capitol, research, and development. Not only is the government reducing productivty, living standards and incomes for the future generation, it’s also leaving it to them to have to pay back all this debt which is increasing daily. I don’t completely disagree that there is a chance that wise government spending could be of benefit but seeing as there is a large risk, I don’t think it’s safe to say that this will definitely have a positive outcome.
The crowding out effect does not seem to have any postive impact on the economy, in the short run or the long run. In the short run, interest rates go up, while quanity decreases. In the long run this causes investment to drop, which in turn will cause a slow down in long run growth. However this effect may be desired. The government can spend money, but this according to the crowding out effect this would only slow down the government, no speed it up, and the spending would then have no purpose.
I agree with Lloyd that the government needs to spend the money now before things get worse. Though the consequences of “crowding out” may be large, if the government waits any longer things can and will get much worse. The economy needs to be brought out of the current recession, and though the “crowding out” effect will increase interest rates and lower investment, the increased government spending will increase the amount of money. If the government focused on spending on locally made products, the nation’s GDP will increase, meaning the economy for the country will grow. Yes, the public will not like the increase in interest rates, but in the long-run the economy will grow and the economy will set itself to equilibrium. I think both the ideas of Keynesian and classical economists need to be kept in mind.
Although we are currently in a difficult situation of a recession and spending money in order to “save” the economy, in the long run, it might not even benefit us at all. There might not be a difference between the situation we’re in now and what situation we’ll be in in the future. In the long run, recessions are hard to antcipate so it’s not possible to know whether spending money now will actually benefit the economy at all in the future. However, if we spend money now, we can fix the economy in the short run and in the long run if it happens again, we can come up with another way to save the economy. However, if we continue to do this, we would end up spending more money than necessary. In our classical opinion, we believe that money shouldnt be spent and that the economy will fix itself in the long run – even though, clearly, this will be a much more lengthy process.
As far a myself, Justin and Matt can see crowding out is a good thing for the economy as more money will be pumped into the economy. The government has no other option that to use borrowed money as they simply cannot supply all the money. This however has a negative effect on interest rates as they will increase from the current 0.5% discouraging investors from investing in the economy. The government could either do this or use supply side policies.
I simply don’t understand why the government is spending over a trillion dollars if it is not even sure that the stimulus package is going to work. How do we know that the Keynesean view is right? Even if it was to increase aggregate demand, in the long run, aggregate supply shifts back and we are left with only an increase in price level. Additionally, the government has now just dug itself deeper into its debt hole and financed this package with the money of the people who buy its bonds. Like the article said, this decreases private investment and may even shift long run aggregate supply left. I do think that the money spent on education, renewable energy and transportation is a good thing, however this only makes up a fraction of the bill. Apparently the bill included 600million dollars of spending to make it easier for people to convert from analog to digital TV…
1.In evaluating the use of expansionary fiscal policy, we learn in IB Economics that the crowding-out of private investment will reduce the expansionary effect of increased government spending. Is crowding-out a problem during a recession? Why or why not?
“Crowding-out of private investment” could be a problem during recession since the government will in this case borrow the money from banks which will increase the investment rate. If the investment rate is increased people will prefer saving their money on their bank account and earning from the increading investment rates, than investing. Firms and People will therefore invest less, which leads to a drop in consumption and therefor GDP, which is the opposite of what is wanted.
BUT crowding-out of private investment is also a smart step of the government to take, since they do not pay their fiscal policy by tax money. If they would do this, the disposable income of people would drop and consumption would go down and also GDP.
Discuss the following statement: “In order to finance its budget deficit, the US government must borrow from the private sector.” How does the government borrow from the American people?
If people put their money on the bank the bank can lend this money to the government. Of course there are interest rates which will be paid to the saver. Through this the government can borrow from a private sector and not only from foreign countries.
Will fiscal stimulus in the short-run lead to increased growth or decreased growth in the long-run? Discuss.
Fiscal stimulus might lead to a decreased growth in the long run since as explained bevore a government dept is created. Additionally if the money comes from the private sector (taxes or bank loans) consumption could be affected
Obviously if they boost the short term macroeconomic situation, they can provide ways to stop a long term readjustment back to the recessive state. Also, people simply need to understand where to invest for the long-run. Discouraging the purchase of government bonds and encouraging the purchase of stocks in the private markets would help in the first place.
Tim has a point. We don’t really know if the expansionary fiscal policy will actually work.. It’s all theoretically pretty smart and ideal but we can’t be 100% certain that the real world will be as pleasant. Equally, if the worst happens, the US will only be left with a dept which will further exacerbate the mess we’re in.
Nevertheless, I think it is worth trying because the plan is somewhat viable and it could be a start if not anything else.
The US government can borrow their money from the people by the use of government bonds or by borrowing it from banks.
The aim of expansionary fiscal policy is to increase AD by increasing consumption, investment and net exports. However it is not certain if it will have a great effect. If consumption does not increase for whatever reasons, then investment and net exports will also not increase, causing the government to end up with a debt and little result with expansionary fiscal policy. In the short-run (if consumption increases) then GDP should also increase, however this could have several side effects in the long run that would cause a decrease in growth such as inflation and debt.
1) Crowding-out is not a problem during the recession, rather a problem in the long-run. However it will help close the recessionary gap and therefore will correct the problem for the time being. The prospect of 4 million new jobs and growth in the US economy within two years cancels out the possible slowed growth in the long run. Plus, further measures can be taken later on in the long run to correct the sluggish growth.
2) The government borrows from the American people by using the money they invest in government bonds.
Anything that will raise GDP and employment is a good sign, anything that will slowly bring us out of the recession. Nevertheless the decrease in supply of loanable funds can increase the interest rates thus decreasing the quantity demanded of loanable funds by firms and households.
The government “borrows” money from the Americans in the forms of bonds that they invest in to finance the budget deficit.
Fiscal stimulus will help lead to decreased growth in the long run due to the decrease in private sector investment. It could very well slow down the economy in the long run.
I dont think crowding out is a problem since the cause of it, is positive in the short run. In the long run, its a good argument for the classical take on macroeconomics, since it decreases GDP, but the alternative to government intervention could be alot worse. I’m very critical of the claim that cowding out will decrease GDP, since a recession will do that anyway. .1-.3 percent in comparison to which figure, what GDP would have been if there had not been government intervention? Its not, its just a comparison of GDP then, and now, which is a flawed idea, since between then and now technology will change, and quality of goods will increase, and there is no way they can predict any increases in quality or quantity. Also GDP says nothing about quality of life, which would have plummeted had the government not intervened, and though the Economy may become sluggish in ten years time, at least they will be living in a stsate better than the population during the great depression. Crowding is an undesired yet necissary side effect if we are to save the world economy.
I do not think that crowding out will cause problems in the recession itself because the positive short run effects help the economy back up. The only problem with “crowding out” are the long run effects, in ten years the economy might experience a decrease in investment due to crowding out. But I think that it is important to remember that the fiscal stimulus package is just a theoretical idea like Alex Han said, and that we cannot be sure of what the future will bring us.
The government borrows money from the private sector, by selling government bonds to households in order to invest the money into the recessionary gap.
The fiscal stimulus package will lead to increased growth in the short run due to higher consumer confidence, but it will also lead to a decrease in growth in the long run due to a decrease in private investment.
Although Tim has a good point, I agree with Loyd that the short run effects outweigh the long run effects. If the fiscal policy fails and unemployment doesn’t decrease there will be a huge decrease in GDp, whic would increase price level and increase unemployment even more in the long run. However if the the government is successful by injecting money into the economy over 4 million new jobs will be created and the unemployment level will fall back close to full employment, there will be an approximate 4% increase in GDP, and the world economy will be on the right track.
Even though it is yet uncertain if the fiscal stimulus will take the desired effects, as many of you already said it is worth taking that risk because of the positive short-run effects. The government has to intervene in the short-run otherwise the economy will fall into an even deeper recession. The classical view that the economy will self-correct due to flexible wages might be true for the long-run, however in the short-run the government has to intervene otherwise we are all dead in the long run as Keynes used to say.
I agree with most of you that crowding out will not cause problems in a recession due to the beneficial short term effects. But I agree with Aleya that crowding out can cause long run problems with a decrease in investment.
The government borrows from the private sector through government bonds.
I think fiscal policy will first lead to an increased growth in the short run, but like many said before it could result in government debt and thus causing a decreased growth in the long run. And if for example the government lowers income taxes, raising GDP, they might have to increase them at some point again which easily can cause a decrease in GDP.
Crowding-out private investment is more of a problem in the long-run when in a rescission. It will reduce unemployment closing the recessionary gap and correct the problem in the short-run. If the government stimulus is injected correctly, the confidence of the consumers better, and possibly solve the problem in the long-run as well, even if the GDP slightly decreases at first.
The government borrows from the American people by selling bonds to the private sector, and giving back the money with a small but safe interest, in a specified amount of years.
The fiscal stimulus package will lead to increased growth in the short run as the changes will be made to increase confidence, increasing GDP , but the changes may also have to be taken back in the long-run, decreasing growth then, but hopefully resulting with less damage to the economy than without the changes in the short-run.
Will fiscal stimulus in the short-run lead to increased growth or decreased growth in the long-run?
In the short-run, a fiscal stimulus could lead to increased growth. Firms will have money to invest and produce, this creates jobs or higher wages. With higher wages and more confidence private households are consuming more.
In the long-run however, the Government might have to raise taxes to pay back its debt. This will lead to a decrease in the nations GDP. If the economy is lucky, the short-run growth outweights the long run tax increase.
Hey jabbobb. I only partially agree with what you say. In the long run, we must suppose that the economy is no longer in a bad state. The government would definitely have to raise taxes, but I think this would be a good thing considering this could counter excessive inflation and thus a possible new recession. Then again, is it likely that an economy will restore its growth in a year or two? Probably not, so in that aspect your probably right. I however think the larger problem is the bubble the government creates. Suddenly there is a large demand. Firms hire new employees, invest in capital, etc. But when the economy is on the right path again, the gov. will stop spending excessively, and all of those people employed to build bridges, roads, schools, etc. will no longer be needed in such large quantities anymore. Again, we will have more people Unemployed, and a lower AD, and a decrease in GDP…
I agree with Bjorn that we should believe that in the long run the economy will no longer be in a bad state. but i believe that in one or 2 years we will have the economy restored if it is already coming out of the trough now.
i do agree with jabbobb about the long run in which the government will av to raise taxes to pay back the dept.
I think the Keynsian approach to get out of this recession is the right way to go. Although it is not sure whether the expansionary fiscal policy will get us out of the recession quicker than leaving the economy as it is, it does create more aggregate demand. I believe the government stimulus will increase the economic growth in the short run and could lead to a long-run growth in the economy if the money is used responsibly and effectively. Otherwise, the increased spending could lead to a bubble effect, as Bjorn Borgers put it and pop some time in the future.