Friday, 31 August 2012

In this age of Big Government, don't forget the crowding-out effect

Running a government is an expensive endeavour and normally becomes ever more expensive as bureaucracies tend to expand over time. But it is not just the direct costs of running it that makes it expensive, it's also the indirect costs involved. This is the focus of the "crowding-out" effect. Here is a quick reminder and explanation of it as written by the Ludwig von Mises Institute,

Crowding-out is a term used to describe the effect that government borrowing has on private investment. When a government borrows money, capital is diverted from private hands, thereby reducing the amount of loanable funds available to private investors. All else being equal, namely the money supply, this will cause interest rates to rise, discouraging firms from expanding their operations.
Crowding-out also occurs with other capital, such as labor or raw materials. When these are used or consumed by government, it follows that they cannot be employed by private actors. Everyone sees the effects of government spending, such as public works projects or a new bridge. What is not so easily recognized however, are examples of the “not seen,” which Frédéric Bastiat described in his essay “That Which Is Seen, and That Which Is Not Seen.” Because capital was used in the construction of a new bridge, it cannot be used to expand a nearby factory.
The crowding-out effect is one reason Murray Rothbard said government spending should be subtracted not only once, but twice, from the reported GDP figure to get a more accurate picture of the actual value created (see for example here).


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