The Crowding Out Effect of Government Spending Will Be Large If Key Factors Align

Government spending can stimulate economic growth, but it can also have unintended consequences. One concern is the “crowding out effect,” where increased government borrowing reduces the availability of funds for private businesses and consumers. This can slow economic expansion if certain conditions are met.

Several factors determine the severity of this effect. Understanding these conditions helps assess whether government spending might hinder rather than help economic activity.

High Government Borrowing Levels

When a government borrows heavily, it competes with businesses and individuals for capital. This increased demand for funds can push up interest rates, making it more expensive for private borrowers to secure financing. The impact depends on the scale of government debt relative to the economy. In the United States, the national debt surpassed $34 trillion in early 2024, with annual deficits exceeding $1.5 trillion. As borrowing grows, investors may demand higher returns to compensate for the risk of lending to a government with rising debt obligations.

Investor confidence influences how government borrowing affects private sector access to capital. If markets believe a country can manage its debt, the impact may be limited. However, concerns about long-term fiscal sustainability can lead investors to favor government securities over corporate bonds or business loans, making it harder for small and mid-sized firms to secure funding.

Tight Credit Conditions

When financial institutions become more cautious about lending, businesses and individuals may struggle to access capital. Banks assess risk based on economic stability, borrower creditworthiness, and regulatory requirements. If lending standards tighten, even financially sound borrowers may find it harder to secure loans, limiting expansion and investment.

Regulatory policies also influence credit availability. Higher capital requirements force banks to hold more reserves, reducing the amount they can lend. In the U.S., the Federal Reserve’s stress testing framework evaluates banks’ ability to withstand downturns, sometimes prompting them to scale back lending. Financial institutions may also adjust risk models in response to uncertainty, leading to stricter loan approvals.

Large corporations often have alternative financing options, such as issuing bonds or accessing international capital markets, but small and medium-sized enterprises (SMEs) rely heavily on bank loans. When credit tightens, these businesses may struggle to maintain operations or grow. Startups, which depend on venture capital or private lending, can also face funding shortages if investors become more risk-averse.

Elevated Interest Rates

Higher borrowing costs affect businesses and consumers alike. Companies must allocate more revenue toward debt payments, leaving less capital for expansion, hiring, or research and development. Households face similar pressures, with higher mortgage rates increasing monthly payments and rising credit card interest making everyday purchases more expensive. These factors can slow consumer spending, a key driver of economic growth.

The stock market reacts to rising interest rates as investors reassess the value of equities relative to fixed-income securities. When bond yields increase, investors may shift funds away from stocks, leading to lower valuations and reduced market liquidity. This can be particularly challenging for publicly traded companies that rely on strong stock prices to raise capital. Additionally, companies with variable-rate debt see borrowing costs rise, cutting into profit margins.

Real estate markets also feel the effects. Higher mortgage rates reduce affordability, slowing home sales and lowering property values. Commercial real estate faces similar challenges, as businesses reconsider expansion plans or lease agreements due to increased financing costs. Developers may delay new projects if construction loans become too expensive, limiting future supply and affecting job creation in the sector.

Strong Competition for Funds

When multiple entities seek financing from the same capital pool, securing favorable terms becomes more difficult. Institutional investors, such as pension funds and asset managers, allocate resources based on risk, return, and liquidity considerations. If government securities offer attractive yields with minimal risk, capital may be diverted away from corporate debt, municipal bonds, or equity markets, reducing available funding for other sectors.

Private firms that rely on capital markets for funding may find themselves competing with more secure government-backed instruments. This can lead to higher spreads on corporate bonds, making it more expensive for businesses to issue debt. Investment-grade companies may still find willing lenders, but those with lower credit ratings could struggle to refinance existing obligations or raise new capital. In leveraged loan markets, where firms with significant debt loads seek funding, this competition can result in tighter conditions and reduced access to liquidity.

Low Private Savings

The availability of domestic savings affects whether government borrowing displaces private investment. When households and businesses save less, there is a smaller pool of funds available for lending, increasing competition for capital. If government debt issuance absorbs a large portion of these limited savings, private borrowers may face higher costs or reduced access to financing.

Demographic trends influence savings rates, as aging populations often draw down their savings rather than accumulate new wealth. In countries with aging workforces, such as Japan and parts of Europe, declining household savings can exacerbate funding shortages. Additionally, economic uncertainty or weak wage growth may discourage individuals from setting aside money, further constraining available capital. In the U.S., the personal savings rate has fluctuated significantly in recent years, falling below pre-pandemic levels in 2023. A sustained decline in savings could amplify the crowding out effect by making private investment more dependent on foreign capital sources.