How Government Crowds out Private Investment

Steve Davies,

Release Date
August 19, 2011


Gov't Debt & Spending

Investment capital is scarce, which necessarily implies that there is a trade-off between government bonds and other types of economic activity. Put another way, investing $1.00 in government debt ensures that the same $1.00 will not be used for private investment or goods and services. According to historian Stephen Davies, government spending will almost always (or perhaps always) be less productive than private spending. This is because government agents spend other people’s money on somebody else. Additionally, government spending operates outside the realm of profit and loss, making it difficult to detect whether or not resources are being wasted.

How Government Crowds out Private Investment
The phenomenon of crowding out is one of the key things to understanding accounts of public spending. Ultimately, there’s only a certain amount of investment capital around. To the extent that the government is using that money, whether for investment or for current spending, it’s not available to other people. So, if the government sells lots and lots of bonds to private investors and uses the money it gets from selling the bonds to fund its current spending, those private investors are not investing in other kinds of economic activity which might well be more productive than investing in government debt, given that the government activity may not be very productive.
The question of whether or not government money is always going to be less productive than private spending is, ultimately, an empirical one. We can say that, in principle, we would expect this to be the case. That’s because, generally speaking, if you’re spending your own money on yourself, you’re going to do it very carefully. If you’re spending somebody else’s money on yourself, you’re also going to be reasonably careful about it. However, if you’re spending somebody else’s money on somebody else, which is what is the case with governments, then you have no real incentive to use that money effectively or efficiently. And there are many, many examples from history that bear this out.
There is a case for saying that there are certain kinds of spending which are more efficient when carried out by government because of the economies of scale that government possesses. However, this is almost always outweighed, and I would argue in fact, always outweighed by the huge inefficiency costs that come with the less productive public management and the fact that public provision does not face the profits and loss incentives which lead private providers to constantly look to improve the quality of their service and cut out wastes and unnecessary costs.