May 14 2009

A must read for AP Macro teachers: Paul Krugman explains why deficit spending during a recession does NOT cause crowding-out

Liquidity preference, loanable funds, and Niall Ferguson (wonkish) – Paul Krugman Blog – NYTimes.com

Below is the loanable funds market at its current equilibrium, according to Krugman (I is investment demand for funds, S is the supply of loanable funds):
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In Krugman’s words:

In effect, we have an incipient excess supply of savings even at a zero interest rate. And that’s our problem.

So what does government borrowing do? It gives some of those excess savings a place to go — and in the process expands overall demand, and hence GDP. It does NOT crowd out private spending, at least not until the excess supply of savings has been sopped up, which is the same thing as saying not until the economy has escaped from the liquidity trap.

In AP Macroeconomics, we teach that deficit-financed government expenditure decreases the supply of loanable funds as savers take their money out of commercial banks and invest in the bond market due to the attractive interest rates on government debt. Less funds available for the private sector drives up interest rates and crowds out private investment.

If the economy is producing close to the full-employment level and interest rates are positive, the decrease in supply of loanable funds can indeed drive up equilibrium interest rates and lead to the “crowding-out” of private investment. Krugman points out in this article that when the economy is at the “zero-bound” (i.e. when nominal interest rates are as low as they can go) and the quantity supplied of savings is still greater than the quantity demanded for investment, the government can effectively borrow from the public, decreasing the supply and correcting the surplus of savings without driving up interest rates in the private market. Put another way, the equilibrium interest rate is below zero, but the “zero-bound” acts as a price floor in the loanable funds market, resulting in a surplus of savings.

Government borrowing crowding out private investment is not something we can worry about during a recession, when low confidence and expectations have driven the supply of savings up and the demand for investment down. Public spending will divert funds from the private sector to the public sector, that’s true. But in today’s case, savings are sitting idle in the private sector, so government borrowing is putting those fund to use when the private sector has failed to do so.

Discussion Questions:

  1. Why does the supply of loanable funds (S in the graph above) slope upwards? Why does the demand for loanable funds (I in the graph) slope downwards?
  2. Deficit financed government spending decreases the supply of loanable funds. Why?
  3. Crowding-out is not the only possible down-side of deficit spending by the government. What are some other long-term effects of governments running budget deficits year after year?

About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author


5 responses so far

5 Responses to “A must read for AP Macro teachers: Paul Krugman explains why deficit spending during a recession does NOT cause crowding-out”

  1. Andyon 14 May 2009 at 7:14 pm

    But is it as obvious as Krugman seems to think it is that the equilibrium interest rate is below zero? Does it necessarily follow from the Fed estimating that having a negative interest rate would provide more stimulus? In a "normal" recession, will Krugman argue that there is some crowding out, and if so does that go against the simple Keynesian story?

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  2. Jason Welkeron 14 May 2009 at 10:43 pm

    Hi Andy,

    With the federal funds rate effectively at 0% and credit markets still frozen, what conclusion are we to draw other than that equilibrium ir must be below 0%. Negative interest rates, were they possible, would create the incentive to borrow and spend, but without the ability to lower commercial rates below the zero bound, there is room for government borrowing and fiscal stimulus without the fear of crowding out.

    I am not sure what you mean by a "normal" recession. By the textbook definition, the current recession is a normal one… caused by a fall in consumer spending, investment and exports, a reduction in aggregate demand, falling output and employment, and downward pressure on the price level. In fact, as an econ teacher, the current recession is a perfect example of a normal one, because it has been accompanied by all the predicted outcomes that our AD/AS model predicts should occur during a recession. Certainly, if it were a much milder recession, one in which investment demand had not plummeted as low as it has and in which "liquidity preference" (i.e. the supply of loanable funds) had not increased as much as it has, and if nominal interest rates were still above zero, then we (and I assume Krugman) would expect deficit financed government spending to decrease the supply of loanable funds, drive up interest rates and crowd out private investment.

    I had my students read the chapter from "The Worldly Philosophers" about Keynes last week. Heilbrunner summarizes the Keynesian view of recession as such:

    "A thrifty community will always attempt to save some part of its income. But business is not always in a position to expand its operations. When the business outlook is poor… the impetus to invest will wane. Why should businessmen expand their facilities when the look to the future with trepidation?

    "And therein lies the possibility of depression. If our savings do not become invested by expanding business firms, our incomes must decline. We should be in the same spiral of contraction as if we had frozen our savings by hoarding them."

    My interpretation of this is that Keynes believed expansionary fiscal policy was necessary to unfreeze the idle savings tied up in frozen credit markets. If private households and firms are not borrowing, and instead prefer liquidity, the "spiral of contraction" will only drag us into depression. Public spending is needed to fill the "recessionary gap" between equilibrium national income and full-employment national income.

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  3. Andyon 15 May 2009 at 6:21 am

    Jason,

    Thanks for the response, I am still trying to understand all of the debates about Keynesianism that have resurfaced with this recession. I believe Krugman and others would say being close to the zero-bound makes this different than the normal recession. At the same time he treats his analysis as if it is self-evident for any reasonable economist. But as I understand it not all economists accept the idea of a liquidity trap and its relevance as he does.

    I also think the idea that credit markets are "frozen" is problematic, particularly now that we are past the worst panic period in the banking system and financial markets. Are we really seeing credit-worthy borrowers being completely unable to obtain credit? We should expect the availability of credit to be lower.

    Finally I think what I'm calling the "simple Keynesian story" completely ignores the need for the re-allocation of resources. Because of that, I'm not convinced that there is virtually no opportunity cost of government spending, which seems to be what this analysis entails. I teach AP economics, so I realize that's basically what we are teaching as a first approximation, but we need to be aware of its limitations (as I'm sure you are).

    Great site by the way.

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  4. Jason Welkeron 15 May 2009 at 7:02 am

    Andy,

    Thanks again! I agree with you that there is an opportunity cost of deficit spending, but it is probably just not crowding out in this economy (notice question #3 above). Krugman also acknowledges this in the end of his blog post: "Now, there are real problems with large-scale government borrowing — mainly, the effect on the government debt burden. I don’t want to minimize those problems;"

    The long-run issues associated with a large debt burden are a real concern and one that we should be teaching our students about when they learn about expansionary fiscal policy.

    Thanks again. Jason

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  5. Ralph Musgraveon 06 Feb 2010 at 3:21 am

    Strikes me the whole concept of “crowding out” is meaningless in an environment (the one we live in) where central banks determine interest rates.

    Will additional so called “borrowing” by government drive up interest rates? No it won’t: because central banks have decided that interest rates will remain at about 0.5%. That is, central banks have undertaken in most countries to print and lend to banks whatever amount of money is needed to keep rates at 0.5%. I.e. if government borrowing DID drive up rates, central banks would just print more money.

    Put that another way, if governments do “borrow”, they are borrowing money which the “government – central bank machine” has created. Bit of a farce. I don’t call that borrowing. I call it printing money and spending it.

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