Crowding out and the threat of higher debt

By Jeremy Hutton, Policy Analyst

With the sun out and BBQs blazing, the country seems relatively relaxed about our rising public debt. This is perhaps surprising, given the urgency with which the debt overhang from the 2008 crisis was treated. Commentators, think-tanks and parliamentarians that might once have been hawkish about high levels of debt now seem to see it as an unfortunate necessity. The conventional wisdom is that interest rates are low so the debt repayments should be manageable. David Cameron’s A-word is now unthinkable and any who utter it swiftly shushed, including by the current prime minister. As such, Britain is set not to go over or around the debt mountain, but to burrow right through, hoping that we won’t encounter any bedrock along the way.

This effort to burrow through the mountain may be driven by mass infrastructure spending to increase economic growth. Who doesn’t like new infrastructure and good growth rates? The problem is that this, and the cost of supporting the public sector amid lower tax revenues, will have to largely be paid for by borrowing. A highly optimistic perspective would be that higher growth, a wealthier economy and increased tax revenues will mean it can be paid off in a few years. 

But what if higher public debt actually slows down growth and impedes the very economic recovery you are aiming to facilitate?

This line of thinking is called “crowding out” theory. It proffers that countries with higher levels of public debt suffer from lower growth rates if the government fails to stimulate the economy. This is because there is a finite amount of wealth, and so less money is leftover to lend for private ventures. In this way, you could say that any government investing to grow the economy is gambling. If it succeeds in stimulating the economy, the country should enjoy respectable levels of growth. However, if the gamble fails, economic growth might be no higher (or even lower), while taxpayers are burdened with yet more debt to pay.

An additional consideration is that if government spending does indeed reduce the level of finance available, then interest rates could rise. For instance, if a bank manager has just £1000 left to lend and five separate people want to borrow it, he will likely end the money to whoever offers him the best repayment terms through higher interest rates. But the bank manager might also be concerned about the ability of the highest bidder to meet those rates, so could ask them for extra assurances regarding the repayments. If one of the five is already asset-rich, he could be considered a safer bet than a competitor who is asset-poor. As such, access to capital (in this case the £1000) is distorted in favour of those who are already better off, whom the lender is more confident will be able to repay the debt.

Now, they don’t call it a theory for nothing. Whether theories like this are reliable relies on a number of factors, not all of which can be easily considered with foresight. Even with hindsight, whether or not crowding out can be blamed for slow growth can never be more than a supposition.

The most common example of crowding out is Britain’s growth during the first industrial revolution. Our recent interactive piece on Britain’s public debt history explains that the 18th century saw more war than it did peace. Accordingly, public debt rose consistently with only brief interruptions. At the same time, Britain experienced sluggish growth rates. Between 1750 and 1794, growth was just 0.94 per cent - half that of the same period a century later, in the more peaceful 19th century, despite that being the era of the ‘Long Depression’. Coincidentally, public debt was by then far lower. But whether crowding out really was the causal factor for the low growth remains disputed.

More recent studies back-up the theory. A 2019 study of European countries following the 2008 recession found that private investment declined as public debt rose. It further deduced that every 1 per cent increase in public debt was accompanied by a 0.03 per cent reduction in public investment. A 2002 study of 16 OECD countries found investment fell as governments built ‘debt mountains’. Finally, a 2012 study that examined a range of economies over a 200 year period concluded that where public debt was over 90 per cent, countries often tended to experience lower growth for over a decade.

It is clear then, that even if crowding out remains unproven, the theory has some credence. Borrowing to spend - with low interest rates and no apparent economic implications - may turn out too good to be true. There are safer ways of navigating this mountain. The government should look at options which are proven to work including reducing the administrative burden on businesses, lifting unnecessary regulations and lowering the tax burden to promote jobs and investment. To quote my boss John O’Connell, the government should be “shamelessly pro-growth” and liberalise the economy so that we can grow our way out of this mountain of debt. In this way, Britain may yet emerge from the shadow of the current crisis a savvier and more entrepreneurial place, better suited to making the most of future opportunities and keeping the books balanced.

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