Learning Objectives

Learning Objectives

By the end of this section, you will be able to do the following:
  • Explain crowding out and its effect on physical capital investment
  • Explain the relationship between budget deficits and interest rates
  • Identify why economic growth is tied to investments in physical capital, human capital, and technology

The underpinnings of economic growth are investments in physical capital, human capital, and technology, all set in an economic environment in which firms and individuals can react to the incentives provided by well-functioning markets and flexible prices. Government borrowing can reduce the financial capital available for private firms to invest in physical capital. But, government spending can also encourage certain elements of long-term growth, such as spending on roads or water systems, on education, or on research and development (R&D) that creates new technology.

Crowding out Physical Capital Investment

Crowding out Physical Capital Investment

A larger budget deficit will increase demand for financial capital. If private saving and the trade balance remain the same, then less financial capital is available for private investment in physical capital. When government borrowing soaks up available financial capital and leaves less for private investment in physical capital, the result is known as crowding out.

To understand the potential impact of crowding out, consider the situation of the U.S. economy before the exceptional circumstances of the recession that started in late 2007. In 2005, for example, the budget deficit was roughly 4 percent of the gross domestic product (GDP). Private investment by firms in the U.S. economy has hovered in the range of 14 percent to 18 percent of the GDP in recent decades. However, in any given year, roughly half of the U.S. investment in physical capital just replaces machinery and equipment that has worn out or become technologically obsolete. Only about half represents an increase in the total quantity of physical capital in the economy. So investment in new physical capital in any year is about 7 percent to 9 percent of the GDP. In this situation, even U.S. budget deficits in the range of 4 percent of the GDP can potentially crowd out a substantial share of new investment spending. Conversely, a smaller budget deficit—or an increased budget surplus—increases the pool of financial capital available for private investment.

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The patterns of U.S. budget deficits and private investment since 1980 are shown in Figure 17.4. If greater government deficits lead to less private investment in physical capital, and reduced government deficits or budget surpluses lead to more investment in physical capital, these two lines should move up and down at the same time. This pattern occurred during the late 1990s and early 2000s. The U.S. federal budget went from a deficit of 2.2 percent of the GDP in 1995 to a budget surplus of 2.4 percent of the GDP in 2000—a swing of 4.6 percent of the GDP. From 1995 to 2000, private investment in physical capital rose from 15 percent to 18 percent of the GDP—a rise of 3 percent of the GDP. Then, when the U.S. government again started running budget deficits during the early 2000s, less financial capital became available for private investment, and the rate of private investment fell back to about 15 percent of the GDP by 2003.

The graph shows that in the case of the United States, since 1980 government borrowing and private investment have often risen and fallen in tandem. The y-axis shows U.S. government deficits/surpluses and private investment as a portion of GDP. The x-axis plots years from 1980 to 2014. It suggests that reduced government borrowing can free up capital for private investment.
Figure 17.4 U.S. Budget Deficits/Surpluses and Private Investment The connection between private savings and flows of international capital plays a role in budget deficits and surpluses. Consequently, government borrowing and private investment sometimes rise and fall together. For example, the 1990s show a pattern in which reduced government borrowing helped to reduce crowding out so that more funds were available for private investment.

This argument does not claim that a government's budget deficits shadow its national rate of private investment exactly; after all, private saving and inflows of foreign financial investment must also be taken into account. During the mid 1980s, for example, government budget deficits increased substantially without a corresponding drop-off in private investment. In 2009, nonresidential private fixed investment dropped by $300 billion from its previous level of $1,941 billion in 2008, primarily because, during a recession, firms lack both the funds and the incentive to invest. Investment growth between 2009 and 2014 averaged approximately 5.9 percent, to $2,210.5 billion—only slightly above its 2008 level, according to the Bureau of Economic Analysis. During that same period, interest rates dropped from 3.94 percent to less than 0.25 percent as the Federal Reserve took dramatic action to prevent a depression by increasing the money supply through lowering short-term interest rates. The crowding out of private investment resulting from government borrowing to finance expenditures appears to have been suspended during the Great Recession. However, as the economy improves and interest rates rise, borrowing by the government may potentially create pressure on interest rates.

The Interest Rate Connection

The Interest Rate Connection

Assume that government borrowing of substantial amounts will have an effect on the quantity of private investment. How does this affect interest rates in financial markets? In Figure 17.5, the original equilibrium (E0), where the demand curve (D0) for financial capital intersects with the supply curve (S0), occurs at an interest rate of 5 percent and an equilibrium quantity equal to 20 percent of the GDP. However, as the government budget deficit increases, the demand curve for financial capital shifts from D0 to D1. The new equilibrium (E1) occurs at an interest rate of 6 percent and an equilibrium quantity of 21 percent of the GDP.

The graph plots the downward-sloping demand and upward-sloping supply of financial capital. The y-axis is the interest rate (also known as the 'price' of financial capital) and the x-axis shows the quantity of financial capital as a percentage of GDP. An increase in government borrowing increases the quantity of financial capital demanded at all interest rates. This is a rightward shift in the demand for financial capital. The graph shows that the equilibrium interest rate will rise.
Figure 17.5 Budget Deficits and Interest Rates In the financial market, an increase in government borrowing can shift the demand curve for financial capital to the right, from D0 to D1. As the equilibrium interest rate shifts from E0 to E1, the interest rate rises from 5 percent to 6 percent in this example. The higher interest rate is one economic mechanism by which government borrowing can crowd out private investment.

A survey of economic studies on the connection between government borrowing and interest rates in the U.S. economy suggests that an increase of 1 percent in the budget deficit will lead to a rise in interest rates of between 0.5 percent and 1.0 percent, other factors held equal. In turn, a higher interest rate tends to discourage firms from making physical capital investments. One reason government budget deficits crowd out private investment, therefore, is the increase in interest rates. There are, however, economic studies that show a limited connection between the two—at least in the United States—but, as the budget deficit grows, the dangers of rising interest rates become more real.

At this point, you may wonder about the Federal Reserve. After all, can the Federal Reserve not use expansionary monetary policy to reduce interest rates or, in this case, to prevent interest rates from rising? This useful question emphasizes the importance of considering how fiscal and monetary policies work in relation to each other. Imagine a central bank faced with a government that is running large budget deficits, causing a rise in interest rates and crowding out private investment. If the budget deficits are increasing aggregate demand when the economy is already producing near potential GDP, threatening an inflationary increase in price levels, the central bank may react with a contractionary monetary policy. In this situation, the higher interest rates from government borrowing is made even higher by contractionary monetary policy, and the government borrowing might crowd out a great deal of private investment.

On the other hand, if the budget deficits are increasing aggregate demand when the economy is producing substantially less than potential GDP, an inflationary increase in the price level is not much of a danger and the central bank might react with an expansionary monetary policy. In this situation, higher interest rates from government borrowing would be largely offset by lower interest rates from expansionary monetary policy, and there would be little crowding out of private investment.

However, even a central bank cannot erase the overall message of the national savings and investment identity. If government borrowing rises, then private investment must fall, or private saving must rise, or the trade deficit must fall. By reacting with contractionary or expansionary monetary policy, the central bank can only help to determine which of these outcomes is likely.

Public Investment in Physical Capital

Public Investment in Physical Capital

Government can invest in physical capital directly: roads and bridges; water supply and sewers; seaports and airports; schools and hospitals; plants that generate electricity, such as hydroelectric dams or windmills; telecommunications facilities; and weapons used by the military. In 2014, the U.S. federal government budget for Fiscal Year 2014 shows that the United States spent about $92 billion on transportation, including highways, mass transit, and airports. Table 17.1 shows the total outlay for 2014 for major public physical capital investment by the federal government in the United States. Physical capital related to the military or to residences where people live is omitted from this table, because the focus here is on public investments that have a direct effect on raising output in the private sector.

Type of Public Physical Capital Federal Outlays 2014 ($ millions)
Transportation $91,915
Community and regional development $20,670
Natural resources and the environment $36,171
Education, training, employment, and social services $90,615
Other $37,282
Total $276,653
Table 17.1 Grants for Major Physical Capital Investment, 2014

Public physical capital investment of this sort can increase the output and productivity of the economy. An economy with reliable roads and electricity will be able to produce more. But, it is hard to quantify how much government investment in physical capital will benefit the economy, because the government responds to political as well as economic incentives. When a firm makes an investment in physical capital, it is subject to the discipline of the market: If it does not receive a positive return on investment, the firm may lose money or may even go out of business.

In some cases, lawmakers make investments in physical capital as a way of spending money in the districts of key politicians. The result may be unnecessary roads or office buildings. Even if a project is useful and necessary, it might be done in a way that is excessively costly, because local contractors who make campaign contributions to politicians appreciate the extra business. On the other hand, governments sometimes do not make the investments they should because a decision to spend on infrastructure not only needs to make economic sense, but also it must be politically popular as well. Managing public investment so that it is done in a cost-effective way can be difficult.

If a government decides to finance an investment in public physical capital with higher taxes or lower government spending in other areas, it need not worry that it is crowding out private investment directly. Indirectly, however, higher household taxes could cut down on the level of private savings available and have a similar effect. If a government decides to finance an investment in public physical capital by borrowing, it may end up increasing the quantity of public physical capital at the cost of crowding out investment in private physical capital, which is more beneficial to the economy would be dependent on the project being considered.

Public Investment in Human Capital

Public Investment in Human Capital

In most countries, the government plays a large role in society's investment in human capital through the education system. A highly educated and skilled workforce contributes to a higher rate of economic growth. For the low-income nations of the world, additional investment in human capital seems likely to increase productivity and growth. For the United States, tough questions have been raised about how much increases in government spending on education will improve the actual level of education.

Among economists, discussions of education reform often begin with some uncomfortable facts. As shown in Figure 17.6, spending per student for kindergarten through grade 12 (K–12) increased substantially in real dollars through 2010. The U.S. Census Bureau reports that current spending per pupil for elementary and secondary education rose from $5,001 in 1998 to $10,608 in 2012. However, as measured by standardized tests such as the SAT, the level of student academic achievement has barely budged in recent decades. Indeed, on international tests, U.S. students lag behind students from many other countries. Of course, test scores are an imperfect measure of education for a variety of reasons. It would be difficult, however, to argue that there are not real problems in the U.S. education system and that the tests are just inaccurate.

The line graph shows that government spending on education has continually increased from 1998 up until 2006, where it leveled off. In 2008, it increased dramatically from $35 to over $70 million. Since 2010, spending has steadily decreased to a little over $40 million in 2014.
Figure 17.6 Total Spending for Elementary, Secondary, and Vocational Education (1998–2014) in the United States The graph shows that government spending on education was increasing continually up until 2006, when it leveled off until 2008, then increased dramatically. Since 2010, spending has decreased steadily. (credit: Office of Management and Budget)

The fact that increased financial resources have not brought greater measurable gains in student performance has led some education experts to question whether the problems may be a result of structure, not just resources spent.

Other government programs seek to increase human capital either before or after the K–12 education system. Programs for early childhood education, such as the federal Head Start program, are directed at families in which the parents may have limited educational and financial resources. The government also offers substantial support for universities and colleges. For example, in the United States, about 60 percent of students take at least a few college or university classes beyond the high school level. In Germany and Japan, about half of all students take classes beyond the comparable high school level. In the countries of Latin America, only about one student in four takes classes beyond the high school level, and in the nations of sub-Saharan Africa, only about one student in 20 take university-level classes.

Not all spending on educational human capital needs to happen through the government. Many college students in the United States pay a substantial share of the cost of their education. If low-income countries of the world are going to experience a widespread increase in their education levels for grade-school children, government spending seems likely to play a substantial role. For the U.S. economy, and for other high-income countries, the primary focus at this time is more on how to get a bigger return from existing spending on education and how to improve the performance of the average high school graduate, rather than dramatic increases in education spending.

How Fiscal Policy Can Improve Technology

How Fiscal Policy Can Improve Technology

R&D efforts are the lifeblood of new technology. According to the National Science Foundation (2013), federal outlays for research, development, and physical plant improvements to various government agencies have remained at an average of 8.8 percent of the GDP. About one fifth of U.S. R&D spending goes to defense- and space-oriented research. Although defense-oriented R&D spending may sometimes produce consumer-oriented spinoffs, R&D aimed at producing new weapons is less likely to benefit the civilian economy than direct civilian R&D spending.

Fiscal policy can encourage R&D using either direct spending or tax policy. The government could spend more on the R&D that is carried out in government laboratories, as well as expand federal R&D grants to universities and colleges, nonprofit organizations, and the private sector. By 2014, the federal share of R&D outlays totaled $135.5 billion, or about 4 percent of the federal government's total budget outlays, according to data from the National Science Foundation. Fiscal policy can also support R&D through tax incentives, which allow firms to reduce their tax bill as they increase spending on research and development.

Summary of Fiscal Policy, Investment, and Economic Growth

Summary of Fiscal Policy, Investment, and Economic Growth

Investment in physical capital, human capital, and new technology is essential for long-term economic growth, as summarized in Table 17.2. In a market-oriented economy, private firms undertake most of the investment in physical capital, and fiscal policy should seek to avoid a long series of outsized budget deficits that might crowd out such investment. The effects of many growth-oriented policies is seen very gradually over time, as students are better educated, physical capital investments are made, and new technologies are invented and implemented.

Sector Physical Capital Human Capital New Technology
Private New investment in property and equipment On-the-job training Research and development
Public Public infrastructure Public education Job training Research and development encouraged through private sector incentives and direct spending.
Table 17.2 Investment Role of Public and Private Sector in a Market Economy

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