Principles of Macroeconomics / Unit 15 MAC 1420 review, 2 to 3 minutes
Does Government Borrowing Hurt Growth
The idea
The question this unit exists to answer cannot be answered yes or no. Start from the identity: private saving plus the inflow from abroad equals private investment plus government borrowing, always. So when borrowing rises, one of three things happens, and each has a different consequence for growth. If private investment falls, the capital stock grows more slowly and future output is lower: that is the crowding-out case, the one usually meant. If private saving rises to meet the borrowing, nothing else need change: that is the Ricardian case, and the evidence puts the offset at roughly a third rather than the whole. If the funds come from abroad, domestic investment is preserved but the return on it flows out in future, and the trade deficit widens. The identity guarantees one of these occurs. It does not say which, which is the first reason there is no general answer.
In practice
Worked example, the same borrowing under two conditions. An economy near potential borrows an extra three percent of output. Lenders are fully employed, the interest rate rises, the central bank leans against the inflation risk and raises rates further, investment falls, and the capital stock grows more slowly: borrowing here does reduce future output. Now the same economy, deep below potential with rates near zero and idle capacity. The government borrows the same amount. Rates barely move, because there are unused funds and a central bank holding them down; investment is limited by weak demand rather than by the cost of funds, so it does not fall; and the spending raises output toward potential. Same borrowing, opposite effect on growth, and the difference is entirely in the conditions.
Where people slip
Three cautions. First, what the borrowing bought matters as much as its size: borrowing that funds roads, schools or basic research adds to the capital the economy works with, so private capital displaced is partly replaced by public capital — fewer office buildings and more schools. Second, the empirical record does not settle this. The witness states that studies of crowding out have been inconclusive and the question remains controversial; the anchor's evidence runs both ways, with investment rising as deficits fell in the late nineties and holding up as deficits grew after the Great Recession; and one study found the effect depends on the type of spending. Third, none of this makes sustained large deficits safe. The anchor lays out two further risks and concedes the causation is unclear: interest costs absorb a growing share of the budget, and a government owing debt fixed in nominal terms is tempted to inflate it away. And chronic deficits financed by short-term foreign money leave an economy exposed to a sudden outflow — unit thirteen's currency mismatch from the fiscal side.
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