The Impacts of Government Borrowing

This is Unit Fifteen of Principles of Macroeconomics: the impacts of government borrowing. Unit fourteen asked what a government's budget does. This unit asks what its borrowing does to everybody else. Carry one idea through. A single identity runs under this whole unit, and every result is a consequence of it — but an identity constrains what can happen without predicting which one will. That gap is where the arguments live, and the capstone answers the unit's question with it depends, then says precisely what it depends on. By the end you will apply the identity and say what must adjust, trace borrowing to investment through the interest rate, tell the same story through the exchange rate, judge whether crowding out will be severe or slight, and classify an act of investment by who does it and what it builds.

Three entries on where borrowed funds come from, and the identity that governs everything after.

Where the funds come from.

MAC 1401 Three Places the Money Can Come From

When a government borrows more, the funds come from one of three places: households can save more, firms can borrow and invest less, or the money can come from abroad. There is no fourth source. Each is a real change somewhere else in the economy, so the borrowing is not free of consequence whichever supplies it.

The identity itself.

MAC 1402 The Identity That Governs Everything

Private saving plus the net inflow from abroad equals private investment plus government borrowing. It is an identity, so it holds always, and every result in this unit follows from it. Rearranged, investment equals private saving, plus public saving, plus the inflow from abroad. Check which side each term sits on before computing, because a surplus moves a term across.

Putting numbers in it.

MAC 1403 Applying the Identity

Given a rise in government borrowing, work out what must adjust: write the identity, put the figures in, change the borrowing term, and see what the others have to do. Start with private saving of fourteen hundred, an inflow from abroad of three hundred, investment of fifteen hundred and borrowing of two hundred. Both sides come to seventeen hundred. Now let borrowing rise to five hundred. If saving and the inflow do not change, investment must fall to twelve hundred: crowding out in full. If households instead save an extra three hundred, investment holds at fifteen hundred — and so it does if the inflow rises by three hundred instead. All three are consistent with the same identity, which is the point: an identity constrains the possibilities and does not predict which occurs. Anyone claiming that borrowing must reduce investment is asserting more than the identity can deliver.

Five entries on the first margin: what it claims, how big it can be, the chain it runs through, and when that chain breaks.

Stating it precisely.

MAC 1404 Crowding Out, Stated Precisely

Crowding out is what happens when government borrowing absorbs financial capital and leaves less available for private investment in physical capital. It is a claim about a quantity, not about waste, and the mechanism runs through the interest rate. Crowding out says private investment fell. It says nothing about whether the public spending was worthwhile.

How much there is to crowd.

MAC 1405 Gross and Net Investment

Gross private investment runs at roughly a sixth of output, but about half merely replaces capital that has worn out, so the net addition to the capital stock is much smaller. A deficit of a few percent of output is therefore large against net new investment. Comparing a deficit with gross investment makes crowding out look smaller.

Working the chain.

MAC 1406 Working the Crowding-Out Chain

Trace government borrowing to private investment through the market for financial capital. The government adds to demand for borrowed funds, the interest rate rises, and projects worth doing at the old rate are not worth doing at the new one. Take the course's economy with a rate of five percent and investment of fifteen hundred. Borrowing rises by three hundred, demand for financial capital shifts right, and the rate rises to six percent. Some projects no longer clear their hurdle and investment falls to thirteen hundred and fifty. So three hundred of borrowing displaced a hundred and fifty — partial, not complete. The anchor reports a consensus that borrowing of one percent of output raises long-term rates by half a point to a full point. Full crowding out, where every dollar borrowed displaces a dollar of investment, is the limiting case rather than the normal one.

The same chain reversed.

MAC 1407 Crowding In

The mechanism reverses. A smaller deficit reduces government borrowing, so the interest rate falls and private investment rises. That is crowding in, the mirror image rather than a separate theory. Public spending can also crowd investment in directly, by building what firms then use. One study found infrastructure crowded private investment out while health and education crowded it in.

When it does not happen.

MAC 1408 When Crowding Out Is Suspended

The chain depends on borrowing raising the interest rate. When rates are already near zero and lenders are abundant, extra government borrowing need not raise them, and investment need not fall. After the Great Recession, deficits grew while investment held up and rates stayed near zero. The anchor's own verdict is that crowding out appeared to be suspended then.

Three entries on the third margin: money arriving from abroad, and how reliably the two deficits really move together.

From one deficit to another.

MAC 1409 From Budget Deficit to Trade Deficit

A budget deficit raises aggregate demand, and some of that spending buys imports. Foreigners accumulate the currency and invest it back, which finances the deficit, so a trade deficit often accompanies a budget one. The money that leaves as payment for imports returns as purchases of assets. This is the third term of the identity moving, not a separate phenomenon.

The same story, told twice.

MAC 1410 Tracing the Chain Through the Exchange Rate

Tell the budget-to-trade story a second way, through unit thirteen's market, and check that both routes agree. Government borrowing raises the domestic interest rate, higher returns attract foreign funds, the currency appreciates, and an appreciated currency widens the trade deficit. The rate rises from five to six percent. Foreign investors want domestic assets, so demand for the currency rises while domestic holders supply less, and it appreciates from ten pesos per dollar to eleven. Apply unit thirteen's result: exports cost foreign buyers more and imports cost domestic buyers less, so net exports fall. The two routes are one process seen twice, not two effects to be added, and adding them would double-count. Unit thirteen's warning applies here too: when both currency curves shift the same way, the direction is certain and the quantity is not.

How reliable that link is.

MAC 1411 Twin Deficits Are Cousins

The budget deficit and the trade deficit are called twin deficits, and the name overstates the link. They rose together in the mid eighties, but in the nineties a budget surplus sat alongside a widening trade deficit. The identity has other terms and any can move instead, so cutting one deficit does not reliably cut the other.

Two entries on the claim that nothing need adjust at all, and on what testing it found.

The claim.

MAC 1412 Ricardian Equivalence

Ricardian equivalence argues that households see government borrowing as a future tax bill and save more against it. If the offset were complete, neither investment nor the trade balance would change. The claim is named for the nineteenth-century economist who first raised it. It is a claim about how far households look ahead, so it is testable.

What testing found.

MAC 1413 What the Evidence Shows

The offset is real and partial. Studies find private saving rises by roughly thirty cents for each extra dollar of government borrowing, and a study across many countries agreed. Saving rose alongside the large deficits of two thousand and eight and of twenty twenty, but not those of the mid eighties, so the size is not stable. So the theory finds a real effect and overstates its size.

Two entries on who decides which margin moves.

The second pass.

MAC 1414 The Policy Mix, Second Pass

Whether crowding out is severe depends on the central bank. If deficits push demand near potential and the bank contracts, it is severe. If output is far below potential and the bank expands, it is slight. Unit fourteen named the four combinations; this is what two of them do. The bank chooses which margin adjusts, not whether one must.

Judging a case.

MAC 1415 Severe or Slight

Given the economy's position and the central bank's response, say whether crowding out will be severe or slight. Two questions settle it: where is output relative to potential, and is the bank leaning with the expansion or against it? The interest rate is where the two policies meet. Output is near potential and the government borrows heavily; the bank, worried about inflation, raises rates. Borrowing already pushed rates up and the bank pushes further, so investment falls substantially: severe. Now output is far below potential with rates near zero, the government borrows the same amount, and the bank holds rates down. Rates barely move and investment barely falls: slight. But slight crowding out is not free, because the identity still requires a margin to adjust: if investment does not fall, saving must rise or the inflow from abroad must, and that inflow is a claim on future output.

Four entries on the other side of the ledger, where governments invest as well as borrow.

The other side.

MAC 1416 Government Can Invest Too

Everything so far treats government borrowing as consuming capital, but governments also invest, in the same three things unit four named as sources of growth: physical capital, human capital and technology. Borrowing that funds investment is different in kind from borrowing that funds consumption. This is why the growth question cannot be answered from the deficit figure alone.

The first kind.

MAC 1417 Public Physical Capital

Roads, ports, water systems, power networks and school buildings raise what the economy can produce, and private firms use them without building them, so public capital can raise output directly. The study named a moment ago found this spending crowding private investment out. Which projects get built is decided politically as well as economically, so value for money is not guaranteed.

The other two kinds.

MAC 1418 Human Capital and Technology

Governments also fund education, which builds human capital, and research, directly or through tax incentives. Both act on long-run supply rather than demand. A sizeable share of public research is defence and space oriented, which spills over less to civilian production. The anchor asks whether more school spending raised measured achievement and does not answer it, and neither does the course.

Sorting the cases.

MAC 1419 Public or Private, and Which Kind

Classify an act of investment by who does it and which of the three kinds it builds, then say which way it moves the identity and long-run supply. Six boxes exist: physical capital, human capital and technology, each done privately or publicly. A firm builds a factory: private physical capital. A government builds a port: public physical capital, financed by borrowing and competing with private borrowers for funds. A household pays for a degree: private human capital. A government funds schools: public human capital, which that same study found crowded private investment in rather than out. A firm runs a laboratory: private technology. A government funds basic research: public technology, with spillovers that private firms could not capture and so would underprovide. That last is the strongest argument in this unit for public investment, and it is about spillovers rather than generosity — which does not establish that any programme is worth its cost.

One entry to close the unit: the question it exists to answer.

Does borrowing hurt growth.

MAC 1420 Does Government Borrowing Hurt Growth

Here the unit's governing idea pays off: 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. If private investment falls, the capital stock grows more slowly and future output is lower: the crowding-out case, the one usually meant. If private saving rises to meet it, nothing else need change: the Ricardian case, and the evidence puts that offset at roughly a third. If the funds come from abroad, investment is preserved but the return flows out in future. The identity guarantees one of these occurs and does not say which, which is the first reason there is no general answer. Take the same borrowing under two conditions. An economy near potential borrows an extra three percent of output. Lenders are fully employed, the rate rises, the central bank leans against the inflation risk and raises rates further, and investment falls: borrowing here does reduce future output. Now the same economy deep below potential, with rates near zero and idle capacity, borrowing the same amount. Rates barely move, investment is limited by weak demand rather than the cost of funds so it does not fall, and the spending raises output toward potential. Same borrowing, opposite effect, and the difference is entirely in the conditions. 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. Second, the empirical record does not settle this — studies of crowding out have been inconclusive, the anchor's evidence runs both ways, and one study found the effect depends on the type of spending. Third, none of this makes sustained large deficits safe. Interest costs absorb a growing share of the budget, and a government owing debt fixed in nominal terms is tempted to inflate it away, though the anchor concedes the causation is unclear. Chronic deficits financed by short-term foreign money also leave an economy exposed to a sudden outflow — unit thirteen's currency mismatch from the fiscal side.

Look at what you can now do. You can apply the identity and say what must adjust, and say why three different outcomes are all consistent with it. You can trace borrowing to investment through the interest rate, and say why partial crowding out is the normal case rather than full. You can tell the same budget-to-trade story through the exchange rate, and avoid counting one process twice. You can judge whether crowding out will be severe or slight from the economy's position and the bank's response, and say what still has to adjust when it is slight. And you can classify an act of investment across the six boxes, and answer the unit's question with it depends, saying precisely what on. Unit sixteen takes these models to economies at very different stages.