EFA (37): Crowding out

Today, in our regular Monday series, Economics for Amateurs, we look at the concept of "crowding out". But first, let me ask a simple question: are crowds good things or not? The, answer, as so often in life, is "it depends".

A negative view of crowds is contained in the common English expression "two's company, three's a crowd". Also, in 1841, the Scottish journalist Charles Mackay published a famous book, Extraordinary Popular Delusion and The Madness of Crowds. This looked at, among other things, the way that the herd behaviour of crowds can lead to disasters, including financial bubbles such as the tulip mania of the early 17th century.

More recently, crowds have had a more favourable press. In 2004, James Surowiecki alluded to Mackay's book when he published his own, called The Wisdom of Crowds, and with an incredibly long subtitle: Why the Many Are Smarter Than the Few and How Collective Wisdom Shapes Business, Economies, Societies and Nations.

Surowiecki's thesis, which is fascinating and controversial, is that crowds — that is, people in general — tend collectively to make better decisions than even the most intelligent individuals.

Another positive view of crowds comes can be seen in modern concept of crowdsourcing. This is the idea of using collective wisdom — in particular, through the internet and online communities — to help companies and individuals solve problems. For some good example, see here.

And what, you might ask, has all this got to do with the economic concept of "crowding out"? To be honest, very little, but I found it fascinating the way crowds have gone from being viewed as something negative to being considered a positive influence.

"Crowding out", on the other hand, is always seen as negative. The idea is that if the government increases its expenditure, it will lead to a reduction, or "crowding out", of private sector consumption and investment.

This crowding out can happen in a number of ways. At a time of full employment and maximum resource usage, any increase in government spending must by definition take resources away from the private sector (firms and individuals).

More subtle forms of crowding out relate to the way the government finances its increased spending. If it raises taxes, the private sector will have lower net income and therefore reduced buying power.

If, on the other hand, the government increases its borrowing to finance spending, the argument is that this will push up real interest rates and thus lead to a reduction in private-sector borrowing and investment.

Economists debate heatedly whether such crowding out is inevitable and how great the effect is. Indeed, some economists argue that, in times of recession and low resource usage, increased government spending can actually lead to a rise, or "crowding in", of private sector investment.. This is the rationale behind the many stimulus plans introduced by governments this year.