On the issue of crowding out

Eugene Fama has written a much maligned post on stimulus packages. As a medium-long term view there is really nothing wrong with it, but the large swath of criticisms that have appeared focus on the fact that the author appears to be implying that there is no short-term stabilisation possible from expansionary fiscal policy – namely, government investment is completely crowded out.

Given that everyone else is talking about it, I thought I would add my relatively inconsequential two cents 😉 . This is from an email I sent along to CPW.


I’m really with Greg Mankiw.

I think that the criticism that Brad Delong laid out – that inventory is counted as investment but is over-valued – is really a second order issue. The main issue with this is that the mix of credit rationing and a flight to quality does support the idea that there is not complete crowding out – contrary to what Fama implicitly assumes. This in turn implies that government spending can smooth the economic cycle.

How does this hold with the S=I identity? I would say that:

  • Given the existence of “low risk” government investment this (an increase in government investment) would lead to an increase in savings to match the increase in investment – people are more willing to loan to government than business after all,
  • Given the presumption of unemployed resources (and credit constraints) there is scope for an exogenous positive shock to invest (which government investment is) to lead to an increase in equilibrium savings and investment – given that the use of unemployed resources creates value which could not be picked up by the private sector because of credit constraints/catatonic fear.

Even if I thought that the US was at potential (which I don’t – I just think the output gap could be overestimated) the whole attitude to risk and credit rationing surely implies that complete crowding out does not hold – sure S=I always holds, but not complete crowding out.

I realise I’m not adding anything to the debate. However, this blog is a good place for me to store things the way I see them at a given point in time, and thats just what I’m doing damn it 😀

If anyone thinks I’m talking crack, feel free to tell me in the comments 😉

Note: In case it isn’t clear the first mechanism reduces consumption, so no instantaneous stimulus even in the face of no crowding out! However, it does allow for a “reallocation” from consumption to investment, if the price signal was screwy for some reason this could be optimal.

The second leads to an indeterminate change in consumption (given the first mechanism – the income effect in of itself will increase consumption), but a net stimulus.

These are important factors to note when we ask “is an increase in government investment increasing output” and furthermore “is an increase in GI increasing welfare” – which is the ultimate goal.

Note2:  There is also the case where public investment is more productive than private investment.  I don’t think this case is as unlikely as people say – given that the government may have easier access to some resources than the private sector (and given the possibility of increasing returns to scale, especially in a small place like New Zealand).