Government Spending Crowds the Private Sector Out and In

June 26, 2013

Most people assume that increased government spending aids the economy and that cuts in spending will hurt it. Even more fear that government spending cuts might push the economy into a recession. These notions are based on the Keynesian belief that the economy is driven by demand, says David Ranson, a senior fellow with the National Center for Policy Analysis.

Indeed, conventional wisdom holds that every dollar the government adds to demand (or subtracts from it) will be multiplied by ancillary changes in private spending. But these claims ignore the fact that the economy has limited economic resources and that government spending actually diverts economic resources away from the private sector.

  • Increased government spending might induce the private sector to contract, a phenomenon known as crowding out.
  • Conversely, cuts in government spending might release economic resources the private sector could put to work more productively.

Historically, large increases in federal spending had a disproportionate effect on the private sector.

  • For the two years in which federal consumption spending rose by between 2 and 5 percentage points of gross domestic product (GDP) (the average increase was 2.3 percent), private sector spending fell 5.9 percentage points, on average, during that and the following year.
  • For the four years in which federal consumption spending rose more than 5 percent of GDP (the average increase was 13.0 percent), private sector spending fell 20.6 percent.

Conversely, large reductions in federal spending also had a disproportionate effect on the private sector:

  • For the three years in which federal consumption spending fell by between 2 and 5 percentage points of GDP (the average reduction was 3.4 percent), private sector spending rose 4.2 percentage points during that and the following year.
  • For the two years in which federal consumption spending fell more than 5 percentage points of GDP, the average reduction was 17.9 percent; private sector spending rose 29.3 percentage points.

John Maynard Keynes said that the economy's resources are all put to productive use at full employment, but when the economy is depressed, increases in government spending have a multiplier effect:  a $1 increase in government spending will increase private output by more than $1. At such times government can compensate for the shortfall in private spending, thereby increasing the economy's total spending and output.

Keynes therefore recommended that deficit spending be confined to periods in which unemployment is high. Thus, Keynes himself was not a "Keynesian" in the sense of someone who believes that government spending always has a positive effect on the economy.

Source: R. David Ranson, "Government Spending Crowds the Private Sector Out and In," National Center for Policy Analysis, June 26, 2013.

 

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