The Wonkish Myth of Crowding Out

Posts in this series

The Deficit Myth By Stephanie Kelton: Introduction And Index
Debunking The Deficit Myth
MMT On Inflation
Reflections On The Deficit Myth
The National Debt Is Soooooo Big

Chapter 4 of Stephanie Kelton’s The Deficit Myth takes up the theory that federal government deficits increase the cost of borrowing by the private sector. Here’s Kelton’s typically incisive description:

In its most common form, the crowding-out myth says that fiscal deficits require government borrowing, which forces Uncle Sam into competition with other would-be borrowers. As everyone competes for a limited supply of available savings, borrowing costs move higher. With interest rates on the rise, certain borrowers — especially private businesses — won’t be able to secure funding for their projects. This causes private investment to fall, leading to a future where there are fewer factories, machines, and so on. With a smaller stock of capital goods, society ends up with a less productive workforce, slower wage growth, and a less prosperous economy. It does sound ominous! P. 101-102.

Given the amount of capital floating around in the world, much of it US dollars, it’s hard to see why this makes sense. The big problem is not the availability of capital for US businesses, but the insistence of the rich that they not be exposed to any risk of loss. What could be a better solution for that than Treasury securities? But the crowding-out theory requires a chain of reasoning, and so it appeals to the self-regard of our wonk class. [1]

Kelton first addresses the idea that there is a limited pool of savings. As she does throughout the book, Kelton uses this myth to discuss the overall picture of money as explained by mainstream economists. They claim that private savings are the ultimate source of the funds that are available to lend. [2] If the government borrows from that limited amount, there is less for others. As you can see, it’s a pinched view of government spending. It seems to mean that government spending is lost somehow, instead of going into businesses and our own pockets, in the US and elsewhere when the government buys from businesses in other countries.

Kelton asks us to consider the flow of dollars in our economy from an accounting perspective. She starts with a two-bucket system: the Federal Government is one bucket, and Everyone Else is the second. Any dollar that leaves the FG bucket goes to the EE bucket. There is no where elso for it to go. Taxes take money out of the EE bucket and put it into the FG bucket. That leads to our first equation:

FG balance + EE balance = 0

So, if there is a FG deficit then there is an EE surplus of like amount.

FG deficit = EE surplus

Deficit spending has a good side! That’s something that seems to elude the practitioners of deficit scare-mongering. On the other hand, if the government runs a surplus, we get

FG surplus = EE deficit.

That seems bad. It means we are losing some of our wealth. Where does that wealth go? Well, it’s cash. Remember that cash is a debt on the government’s books, so the cash it collects in taxes just offsets the debt, and disappears. That might be bad! That’s something else the deficit scare-mongers never mention.

Kelton emphasizes that it’s the net that counts. So, if the FG spends $100 and taxes $90, there is a surplus of $10 in the EE bucket. That’s money in our pockets, increased savings. The federal government can just issue Treasuries in that amount, converting the green dollars into yellow dollars in Kelton’s parlance. So contrary to the myth of crowding out, FG deficits don’t eat up our existing savings, they actually increase the amount of savings. It’s not an opinion, it’s just simple accounting.

At this point we might ask if there was ever any real danger of a shortage of loanable funds. The Fed publishes a weekly summary of the balance sheets of all commercial banks in the US. As of July 1, total loans were $10.6 T and total deposits were $15.6 T. [3]. The Treasury has issued trillions of dollars of securities to cover deficit spending to date and there are still $5 T in available bank credit, and with the multiplier effect [2], there’s much more. There’s plenty more where that came from. Money Market funds have a total of about $4.6 T, all of it short-term, and much of that is available for longer-term investment if there were reasonable returns for the perceived risk. But there aren’t any decent returns to cash right now. Why?

That’s Kelton’s second point. Step 2 in the reasoning chain for this myth is that competition to borrow money drives up interest rates. Not so, says Kelton. She explains that interest rates are a policy choice. The Fed has always been able to control interest rates, both short and long term. In the past, it has done so extensively. During WWII, the Fed kept interest rates at specific levels to help control the economy during the war. That continued until 1951. We have had other bouts of serious control, including immediately after the Great Crash, though that didn’t last long. The Fed is currently keeping interest rates low for both short-and long-term loans.

At other times, the Fed has controlled short-term rates and allowed the private market to affect longer-term rates. Kelton explains how the Fed controls both long- and short-term interest rates, which I’ll skip over. It’s enough to say that this puts the nail in the idea of crowding-out.

Deficits have their good side, but they can create problems, like inflation or politically-driven mis-allocation of resources. MMT doesn’t argue for deficits or surpluses. It argues that we should pay attention to the state of the economy and pick policies that maximize our political desires. I think the government should do more to take care of our citizens. I think everyone should have a job, good schools, decent transportation, clean water and clean air, a planet that isn’t catching fire, and a world not ravaged by Covid-19. MMT supports those goals. Others think we should buy more tanks and guns and do nothing else, just let the market fix things. There are MMT prescriptions for that too.

Finally, it’s worth noting something Kelton doesn’t discuss: keeping interest rates low hurts savers, whether they are saving for a rainy day, for college for the kids, for a down-payment on a home, or retirement. These are funds that people mostly don’t want to put at significant risk. But if interest rates are low, there is a real danger that inflation will slowly erode those savings. For example, health care costs are one reason people save for a rainy day. It’s likely that inflation in that sector is higher than the overall inflation rate. Low interest rates will hurt those savers. Similarly, college costs are rising faster than overall inflation, and in some cities, house prices and rents rise faster. In each case, the saver is a loser.

We should be thinking about that if we want to see progressive uses of MMT achieve their full potential.

[Graphic via Grand Rapids Community Media Center under Creative Commons license-Attribution, No Derivatives]

[1] That’s my view, not Kelton’s. She says there is some evidence that crowding-out can be a problem for non-sovereign currencies, but not for sovereign currencies.

[2] This is accompanied by the idea that bank lending results in deposits, and those deposits fund another round of lending, etc. Each round of lending is smaller because banks are required to hold a percentage of all deposits in their reserves at the Fed. I was taught that this is the multiplier effect; it’s now called the money multiplier. We can ignore it for these purposes, because it leads to a larger number, but still one defendant on savings.

[3] Respectively, H.8, P. 2 Line 9 and H.8 P. 3, line 34.

19 replies
  1. earlofhuntingdon says:

    Keeping interest rates low hurts the little gal. Sure does. The wealthy and those who administer their wealth, tend to be more concerned about preserving asset values, which is a function of inflation. They would take no or low interest, if that’s the cost of preserving asset values. The little guy, with no capital to speak of, needs his cash savings and every dime it can earn. Those into money laundering, too, accept zero or negative interest rates as a cost of doing the laundering, which turns potentially liquid assets into the real thing.

  2. Sandwichman says:

    The funny thing about the “crowding out” hypothesis is that it hearkens back to the old wages-fund doctrine of classical political economy, which implied that there was at any given time a given amount of wage goods available, which formed a limited fund for paying wages. If one group of workers got a wage increase, it would be at the expense of other workers.

    • BobCon says:

      Recent studies of the minimum wage have shown that this belief has been grossly overstated, but it remains extremely potent on the right. They’re weirdly faith-based when it comes to the benefits of ending regulations as a spur to growth, but incredibly formulaic when it comes to entry level employee wages.

    • earlofhuntingdon says:

      I would rather rely on a correctable public government, which has the potential to mis-allocate funds, than any group of private actors of the Koch, Musk, Bezos variety. Their egos rival Trump’s. In their secretive private worlds, and much of the real one, they know no restrictions. They always do what’s best for them, while telling the rest of us that “it” will hurt them more than it will us. No contest.

    • earlofhuntingdon says:

      It also seems to me that running a government and an economy is like sailing: the base course results from frequently tacking left and right into the wind. Mistakes are made. Policies and machinery don’t work, they don’t survive counter-attack, or they are insufficient to attack problems that can’t be addressed directly. These are corrected over and over again. The net process creates the base course.

  3. Zirc says:

    “Kelton emphasizes that it’s the net that counts. So, if the FG spends $100 and taxes $90, there is a surplus of $10 in the EE bucket. That’s money in our pockets, increased savings. The federal government can just issue Treasuries in that amount, converting the green dollars into yellow dollars in Kelton’s parlance. So contrary to the myth of crowding out, FG deficits don’t eat up our existing savings, they actually increase the amount of savings. It’s not an opinion, it’s just simple accounting.”

    For roughly the last hundred years the US has occupied a unique place in the world economy. One of the advantages of that place is that we have had buyers, both domestic and foreign, for our treasuries. Can you, or Kelton for that matter, envision a scenario in which the govt can’t “just issue treasuries” simply because no one wants them? If not, why not? If so, how can we entice those buyers? Are there limits to how high we could raise rates to sell them?


    • Ed Walker says:

      Suppose you are the holder of a large amount of cash, either currency or bank deposits. The alternative to Treasuries is what exactly? Leave your cash in the safe where it gets no return and is theoretically subject to theft? Leave it in a bank, where there is some risk of failure, very low return, and occasionally difficulty in getting it back? Or Treasuries which are easily moved, and safe? Put it in the stock market? Invest in real estate or some new business?

      But here’s the thing: Treasury doesn’t have to sell securities. It is a policy choice that we issue debt securities to match the deficit. The government, we, could simply put the money into the banking system by buying stuff. Or we could hide that by selling the securities directly or indirectly to the Fed, which could remit them and all interest back to Treasury whenever it wanted to.

      To put this in perspective, ask yourself what would happen if we didn’t issue debt securities to match the deficit? The government could still spend, because the Fed would still credit the bank account of the seller. Chinese businesses would see their accounts change in exactly the same way. So, is there a problem?

      • Zirc says:

        Is there a problem? My short answer is “I don’t know.” I want to be convinced by Kelton and you. And while I agree deficits can be positive, especially when the money is spent on genuine infrastructural investment, I am uneasy going all in.


        • DTK says:

          Dear Zirc,

          Then you must be very uneasy-our spending is already “all in”. Spending should avoid inflation and have broad benefit to society. Now, there’s deflation occurring which means ample slack (and resources available) in the economy to absorb the spending. SK and other MMT scholars are thorough in this explanation.

          • Zirc says:

            Fair enough. I am more convinced by Ed’s point below that the economy as is doesn’t work for most of us. The deflation you speak of suggests we can assume more debt, and I am all in on infrastructure investment. I guess I need to dive in more on both SK and Ed’s explanations so I can more readily defend increased debt to others. And I don’t mean to Republicans. Those who supported Bush and currently support Trump clearly aren’t worried about debt; so I don’t care to defend more debt under a Biden administration to them.


        • Ed Walker says:

          I think we never know enough to be sure about things as complex and as poorly understood as the macro-economy. As I see it, the way the economy works now is bad for most of us. I think any change will also produce problems. Maybe as commenter Jim Crittenden says above, the political system will screw up, for example. Or as I note in the post, keeping interest rates low creates a problem for small savers trying to get a bit ahead.

          I think we should try to make changes in such a way that the foreseeable problems seem more manageable, and thus better, than the current set of problems. Conservatives always tell us that congress is unable to make good decisions, I don’t agree, and anyway that’s the only mechanism we have to push for a better society.

  4. DTK says:

    Another good post. Dr. Richard Werner explains the three main theories of modern banking; Banking as financial intermediation, fractional reserve banking, and the credit creation theory of banking. The last one being what actually happens when banks “loan” money.

    • Bruce Olsen says:

      This Richard Werner? “MMT wants the transfer of wealth from the many to the few to be accelerated via further excessive national debt, to be serviced by our children and grandchildren.” Twitter, Jul 28, 2018

  5. earlofhuntingdon says:

    Trump launches another night of the long knives, targeting administrators and agency heads he considers insufficiently loyal. His target is the entire federal government – HHS, Defense, Treasury, Labor, Commerce, and more. He is doing this less than four months ahead of a general election – in the middle of, “a devastating pandemic and a searing economic crisis.” His teams of Inquisitor bishops are ferreting out the unholy, the potentially “disloyal,” those who might leak or commit “other potentially subversive” heretical acts. People they just don’t like will inevitably fall, too.

    The situation is ripe for the kind of payback and career destruction that excites Trump to the bonespur. Apart from giving him the vapors, his Inquisition suggests a circumstance Dick Nixon could only have dreamt about: The president is mounting a full-court press to terrorize would be whistleblowers. He plans to have their departments engage in inappropriate or blatantly illegal conduct, to help him cheat himself into another four years in office. He is warning those who remain not to create evidentiary records of what they’re about to do, because, inevitably, the little guys go down before he does.

    I’d like a chaser with that double shot of paranoia, please.

    • BobCon says:

      One thing to start watching out for is “burrowing in” where political appointees transfer to career civil service jobs right around election time, letting hacks continue to drive policy instead of being let go.

      This article notes that steps were taken a couple of years ago to supposedly make it harder —

      But obviously Trump office chiefs will have no problem greasing the wheels to keep their hacks — and lobbyist favorites — in powerful positions, and I expect the seeding process has already begun.

      • earlofhuntingdon says:

        Yes, that. BushCheney created similar long-term problems, which were among those ignored as part of the look forward, not back regime.

        The wholesale attack on IGs – already explicable as helping Trump to avoid accountability – comes into better focus when moves like these follow it.

  6. Rapier says:

    Much confusion here, about and mixing up of, the two types of borrowing. That is borrowing from banks vs borrowing from ‘investors’. Banks ‘print’ the money they loan so there is in theory no amount that can’t be lent. The limits on bank lending pertain to the amount of risk they will take. In the case the latter, borrowing from ‘investors’, which is what governments do, there is a limit on how much ‘investors’ have in their bank accounts to lend to governments and corporations. Ultimately that limit is the amount of money in bank accounts but not insignificantly also, how much they want to lend in total at current rates.

    The latter case defines a market. There is supply of government and corporate bonds and there is a universe of ‘investors’ looking to earn the interest on loaning money. “Crowding out” is a silly word to describe a supply and demand balance, and thus price. When supply exceeds demand then prices fall. It has to be understood that when the prices of bonds fall that means interest rates rise. Prices fall if supply exceeds demand of course. Even in bonds.The price of bonds is not a derivative of their interest rates, they are the same thing.

    The market in bonds is the result of formal mechanisms which are easily observed every single day. Myths are not formal mechanisms that can be observed every day. Period.

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