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Crowding out and Its Critics

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Crowding out and Its Critics Crowding Out and Its Crities* KEITH NJ. CARLSON and ROGER W. SPENCER OES Government spending displace a near equal can be described in the context of the standard amount of private spending? This notion, popularly IS-LM analytic framework, In this framework, which known as the “crowding- out” effect of Government is the cornerstone of most macroeconomics courses expenditures, has recently gained wide-spread at- taught throughout the western world, the IS curve tention at two levels. Fii-st, at the policy level, public represents the locus of points (pairs of interest rates officials have expressed concern, that massive current and real income) in \vhich the real sector of the and projected Federal deficits will have a deleterious economy is in equilibrium, and the LM curve repre- effect on private capital expenditures for some time sents a similar locus of points for which the demand to come. Second, at the academic level, “crowding for money equals the supply. The IS-Ui apparatus out” is at least one of the issues which helps to dis- has distinct limitations, hut because of its widespread tinguish between followers of the t\vo major macro- use as a pedagogical device, it serves a useful func- economic schools of thought Keynesians and tion in highlighting the issues in the crowding-out 2 monetarists. controversy. This article focuses on “crowding out” from more The subject of crowding out is approached by first of an academic than a practical policy point of view. investigating a number of separate “cases” which pro- Policy implications can he drawn from this discus- vide various explanations of how crowding out might sion, but, for the most part, the abstract economic occur. Next, the role of stability considerations in the models used in academic circles are not easily adapt- controversy is assessed. Finally, several econometric able to observable phenomena. Yet the origins of the models~~treexamined to determine what empirical recent crowding— out controversy at the academic implications they have for the crowding-out issue. level are traceable to certain empirical results based on U.S. experience. New research has been conducted in this area and To set the stage for the discussion, two matters 1 some old arguments have been revived. Many of of a preliminary nature are taken up in this section. the developments in the crowding-out controversy First, crowding out is defined for the purposes at hand. Much of the recent discussion of crowding out °The authors acknowledge the helpful comments of James has been confusing simply because the term has not Barth, William Dewald, Dean Dutton, Thomas l-lavrilesky, Robert Rasehe, Paul Smith, Frank Steindi, and William Yohe, been carefully defined. Second, since the controversy none of whom should be held responsible for remaining 2 errors. For discussion of the limitations of the IS-LM framework, I For a survey that includes a discussion of the views of the see Karl Brunner and Allan II. \ leltzer, “Monetanism ‘lie classical economists on crowdmg out, Sec Roger \V. Spencer Pri ci pal Issties Areas of Agreei ient a 11(1 tllv Work Remain— aad William P. Yohe, “The ‘Crowding Out’ of Private Ex- aig.’’ \Jo tie tOitsoi, ed . 3 eroilie L, Stein, ( Ainsterdam North penditures by Fiscal Policy Actions,” this Review (October Hollaiirl Publishing Co., forthcoming), and ‘Mr. Hicks and 1970), pp. i2-24. the Monetarists, Ecoao,aica (Febmary 1973), pp. 44-59. Page 2 FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1975 has moved through several stages in recent years and that nominal crowding out occurs; that is, a change has oftentimes involved complex and subtle argu- in Federal spending financed by either horrowing or ments, an overview is provided as a guide to the taxes has only a negligible effect on GNP over a reader, period of about a year, These studies did not suggest that expansionary fiscal actions have no effect, but showed instead that the initial effect, which is posi- tive, is followed in later quarters by an approximately Crowding out generally refers to the economic ef- off-setting negative effect. fects of expansionary fiscal actions. If an increase in Government demand, financed by either taxes or The response to these empirical results took place debt issuance to the public, fails to stimulate total at two levels — statistical and theoretical. At the economic activity, the private sector is said to have statistical level, the validity of the results was ques- tioned. Were proper statistical procedures followed been ‘crowded out” by the Government action. The 5 presumption of a constant money supply insures that in their derivation? On the theoretical level the ques- the policy action accompanying the increase in Gov- tion was whether or not the results were consistent ernment demand is fiscal and not monetary. with what seemed to be the accumulated evidence on certain theoretical propositions.° The analysis may be conducted in either real or nominal terms. The crowding-out hypothesis main- Although all the returns regarding the validity of tains that if prices are held constant, as in typical the Andersen-Jordan empirical procedures are not IS-LM fashion, an increase in real Government de- yet in, this article focuses on the theoretical argu- mand financed by real taxes or debt has no lasting ments that have since evolved. The first theoretical effect on real income. Alternatively, crowding out argument offered in response to the crowding out implies that an increase in Government spending, concept was an alleged inconsistency between such results and the prevailing estimates of the interest given flexible prices and a constant money supply, 7 has no lasting effect on nominal income. In other elasticity of the demand for money. The critics words, the steady state Government spending multi- charged, on the basis of the IS-LM framework, that plier, under the ahove conditions, is approximately in order for crowding out to occur, the proponents zero.3 of these results must be assuming that the demand for money is nearly perfectly interest-inelastic, This By approximately zero, we mean that increased allegation meant acceptance of the proposition that Government demand may crowd out exactly the the LM curve is essentially vertical. According to the same amount of private demand, slightly less, or critics, most empirical estimates do not support a zero slightly more. There is complete crowding out if $1 interest elasticity of money demand. of Government demand displaces $1 of private de- mand, partial crowding out if $1 of Government In answer to this charge of inconsistency, Milton demand displaces less than $1 of private demand, Friedman and others argued that the slope of the and over crowding out if $1 of Government demand LM curve was largely irrelevant to the crowding out displaces more than $1 of private demand. The in- on Economic Activity — The Historical Evidence,” this Re- creased Government demand may increase aggregate view (November 1969), pp. 5-24, and “Monetary and Fiscal demand temporarily, permanently, or not at all, as Jillluerices on Economic Activity: The Foreign Experience,” this Review (February 1970), pp. 16-28. will be explained below. 5 See E. Gerald Corrigan, “The Measurement arid importance of Fiscal Policy Changes,” Federal Reserve Bank of New York Monthly Rev-Jew (June 1970), pp. 133-45; Richard C. Davis, “How Much Does Money Matter? A Look at Some The origins of the recent controversy are traceable Recent Evidence,” Federal Reserve Bank of New York Monthly Review (June 1969), pp. 111-31; and Edward M. primarily to the empirical results published by Ander- (;raimi]ieh, “The Usefulness of Monetary and Fiscal Policy sen and Jordan in 1968 and supporting studies by as Discretionary Stabilization Tools,” Journal of Money, Credit and Banking (May 1971), pp. 506-32. Keran in 1969 and 1970.~ These results indicated 6 James Tobio, “Friedman’s Theoretical Framework,” Journal 3 of Political Economy (September/October 1972), pp. 852-63; These definitional issues are explored in more tletail in the Warren L. Smith, “A Neo~KeynesianView of Monetary Pol- appendix. icy,” l”ederal Reserve Bank of Boston, Controlling Monetary ~Leonall C. Andersen and Jerry L. Jordan, “Monetary and Aggregates (June 1969), pp. 105-26; and Ronald L. Teigen, Fiscal Actions: A Test of Their Relative Importance in “A Critical Look at Monetarist Econonucs,” this Review Economic Stabilization,” this Review (November 1968), pp. (January 1972), pp. 10-25. 11-24; Michael W. Keran, “Monetary and Fiscal Influences Tobiii, “Friedman’s Theoretical Framework.” Page 3 FEDERAL RESERVE DANK OF ST. LOUIS DECEMBER 1975 discussion.5 In particular, Friedman pointed out the vertical LM curve as a requirement for the existence necessity of distinguishing between initial and subse- of crowding out. James Tobin, for example, observed quent effects of fiscal actions. According to Friedman, that a vertical LM curve leads to the “characteristic an “expansionary” fiscal action might first be reflected monetarist” proposition that “a shift of the IS locus, in a rise in output, but the financing of the deficit whether due to fiscal policy or to exogenous change would set in motion contractionary forces which in consumption and investment behavior, cannot alter could eventually offset the initial stimulative effectY ~“,h1 William Branson, in his popular macroeconomics textbook, noted that In response to the Friedman explanation, the crit- ics developed still another argument, again pointing The monetarist position is that the interest elastici- ties of the demand for and supply of money are out an alleged inconsistency. This time the critics zero, so that the LM curve is vertical, In this case attempted to demonstrate that the Friedman argu- fiscal policy changes the composition, but not the ment, which stemmed from explicit consideration of level of national output, while monetary policy, shift- the Government’s financing requirements, is not con- ing a vertical LM curve, can change the level of sistent with generally accepted assumptions concern- output.
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