What Does Crowding Out Even Mean?

Paul Krugman is taking some guff for this column where he argues that the US economy is now at potential, or full employment, so any shift in the federal budget toward deficit will just crowd out private demand.

Whether higher federal spending (or lower taxes) could, in present conditions, lead to higher output is obviously a factual question, on which people may read the evidence in different ways. As it happens, I don’t agree that current output is close to the limits of current productive capacity. But that’s not what I want to write about right now. Instead I want to ask: What concretely would crowding out even mean right now?

Below, I run through six possible meanings of crowding out, and then ask if any of them gives us a reason, even in principle, to worry about over-expansionary policy today. (Another possibility, suggested by Jared Bernstein, is that while we don’t need to worry about supply constraints for the economy as a whole, tax cuts could crowd out useful spending due to some unspecified financial constraint on the federal government. I don’t address that here.) Needless to say, doubts about the economic case for crowding-out are in no way an argument for the specific deficit-boosting policies favored by the new administration.

The most straightforward crowding-out story starts from a fixed supply of private savings. These savings can either be lent to the government, or to business. The more the former takes, the less is left for the latter. But as Keynes pointed out long ago, this simple loanable-funds story assumes what it sets out to prove. The total quantity of saving is fixed only if total income is fixed. If higher government spending can in fact raise total income, it will raise total saving as well. We can only tell a story about government and business competing for a given pool of saving if we have already decided for some other reason that GDP can’t change.

The more sophisticated version, embodied in the textbook ISLM model, postulates a fixed supply of money, rather than saving. [1] In Hicks’ formulation, money is used both for transactions and as the maximally liquid store of wealth. The higher is output, the more money is needed for transactions, and the less is available to be held as wealth. By the familiar logic of supply and demand, this means that wealthholders must be paid more to part with their remaining stock of money. The price wealthholders receive to give up their money is interest; so as GDP rises, so does the interest rate.

Unlike the loanable funds story with fixed saving, this second story does give a logically coherent account of crowding out. In a world of commodity money, if such ever was, it might even be literally true. But in a world of bank-created credit money, it’s at best a metaphor. Is it a useful metaphor? That would require two things. First, that the interest rate (whichever one we are interested in) is set by the financial system. And second, that the process by which this happens causes rates to systematically rise with demand. The first premise is immediately rejected by the textbooks, which tell us that “the central bank sets the interest rate.” But we needn’t take this at face value. There are many interest rates, not just one, and the spreads between them vary quite a bit; logically it is possible that strong demand could lead to wider spreads, as banks stretch must their liquidity further to make more loans. But in reality, the opposite seems more likely. Government debt is a source of liquidity for private banks, not a use of it; lending more to the government makes it easier, not harder, for them to also lend more to private borrowers. Also, a booming economy is one in which business borrowers are more profitable; marginal borrowers look safer and are likely to get better terms. And rising inflation, obviously, reduces the real value of outstanding debt; however annoying this is to bankers, rationally it makes them more willing to lend more to their now less-indebted clients. Wicksell, the semi-acknowledged father of modern central banking theory, built his big book around the premise that in a credit-money system, inflation would give private banks no reason to raise interest rates.

And in fact this is what we see. Interest rate spreads are narrow in booms; they widen in crises and remain wide in downturns.

So crowding out mark two, the ISLM version, requires us to accept both that central banks cannot control the economically relevant interest rates, and that private banks systematically raise interest rates when times are good. Again, in a strict gold standard world there might something to this — banks have to raise rates, their gold reserves are running low — but if we ever lived in that world it was 150 or 200 years ago or more.

A more natural interpretation of the claim that the economy is at potential, is that any further increase in demand would just  lead to inflation. This is the version of crowding out in better textbooks, and also the version used by MMT folks. On a certain level, it’s obviously correct. Suppose the amount of money-spending in an economy increases. Then either the quantity of goods and services increases, or their prices do. There is no third option: The total percent increase in money spending, must equal the sum of the percent increase in “real” output and the percent increase in average prices. But how does the balance between higher output and higher prices play out in real life? One possibility is that potential output is a hard line: each dollar of spending up to there increases real output one for one, and leaves prices unchanged; each dollar of spending above there increases prices one for one and leaves output unchanged. Alternatively, we might imagine a smooth curve where as spending increases, a higher fraction of each marginal dollar translates into higher prices rather than higher output. [2] This is certainly more realistic, but it invites the question of which point exactly on this curve we call “potential”. And it awakens the great bane of postwar macro – an inflation-output tradeoff, where the respective costs and benefits must be assessed politically.

Crowding out mark three, the inflation version, is definitely right in some sense — you can’t produce more concrete use values without limit simply by increasing the quantity of money borrowed by the government (or some other entity). But we have to ask first, positively, when we will see this inflation, and second, normatively, how we value lower inflation vs higher output and income.

In the post-1980s orthodoxy, we as society are never supposed to face these questions. They are settled for us by the central bank. This is the fourth, and probably most politically salient, version of crowding out: higher government spending will cause the central bank to raise interest rates. This is the practical content of the textbook story, and in fact newer textbooks replace the LM curve — where the interest rate is in some sense endogenous — with a straight line at whatever interest rate is chosen by the central bank. In the more sophisticated textbooks, this becomes a central bank reaction function — the central bank’s actions change from being policy choices, to a fundamental law of the economic universe. The master parable for this story is the 1990s, when the Clinton administration came in with big plans for stimulus, only to be slapped down by Alan Greenspan, who warned that any increase in public spending would be offset by a contractionary shift by the federal reserve. But once Clinton made the walk to Canossa and embraced deficit reduction, Greenspan’s fed rewarded him with low rates, substituting private investment in equal measure for the foregone public spending. In the current contest, this means: Any increase in federal borrowing will be offset one for one by a fall in private investment —  because the Fed will raise rates enough to make it happen.

This story is crowding out mark four. It depends, first, on what the central bank reaction function actually is — how confident are we that monetary policy will respond in a direct, predictable way to changes in the federal budget balance or to shifts in demand? (The more attention we pay to how the monetary sausage gets made, the less confident we are likely to be.) And second, on whether the central bank really has the power to reliably offset shifts in fiscal policy. In the textbooks this is taken for granted but there are reasons for doubt. It’s also not clear why the actions of the central bank should be described as crowding out by fiscal policy. The central bank’s policy rule is not a law of nature. Unless there is some other reason to think expansionary policy can’t work, it’s not much of an argument to say the Fed won’t allow it. We end up with something like: “Why can’t we have deficit-financed nice things?” “Because the economy is at potential – any more public spending will just crowd out private spending.” “How will it be crowded out exactly?” “Interest rates will rise.” “Why will they rise?” “Because the federal reserve will tighten.” “Why will they tighten?” “Because the economy is at potential.”

Suppose we take the central bank out of the picture. Suppose we allow supply constraints to bind on their own, instead of being anticipated by the central planners at the Fed. What would happen as demand pushed up against the limits of productive capacity? One answer, again, is rising inflation. But we shouldn’t expect prices to all rise in lockstep. Supply constraints don’t mean that production growth halts at once; rather, bottlenecks develop in specific areas. So we should expect inflation to begin with rising prices for inputs in inelastic supply — land, oil, above all labor. Textbook models typically include a Phillips curve, with low unemployment leading to rising wages, which in turn are passed on to higher prices.

But why should they be passed on completely? It’s easy to imagine reasons why prices don’t respond fully or immediately to changes in wages. In which case, as I’ve discussed before, rising wages will result in an increase in the wage share. Some people will object that such effects can only be temporary. I’m not sure this makes sense — why shouldn’t labor, like anything else, be relatively more expensive in a world where it is relatively more scarce? But even if you think that over the long-term the wage share is entirely set on the supply side, the transition from one “fundamental” wage share to another still has to involve a period of wages  rising faster or slower than productivity growth — which in a Phillips curve world, means a period above or below full employment.

We don’t hear as much about the labor share as the fundamental supply constraint, compared with savings, inflation or interest rates. But it comes right out of the logic of standard models. To get to crowding out mark five, though, we have to take one more step. We have to also postulate that demand in the economy is profit-led — that a distributional shift from profits toward wages reduces desired investment by more than it increases desired consumption. Whether (or which) real economies display wage-led or profit-led demand is a subject of vigorous debate in heterodox macro. But there’s no need to adjudicate that now. Right now I’m just interested in what crowding out could possibly mean.

Demand can affect distribution only if wage increases are not fully passed on to prices. One reason this might happen is that in an open economy, businesses lack pricing power; if they try to pass on increased costs, they’ll lose market share to imports. Follow that logic to its endpoint and there are no supply constraints — any increase in spending that can’t be satisfied by domestic production is met by imports instead. For an ideal small, open economy potential output is no more relevant than the grocery store’s inventory is for an individual household when we go shopping. Instead, like the household, the small open economy faces a budget constraint or a financing constraint — how much it can buy depends on how much it can pay for.

Needless to say, we needn’t go to that extreme to imagine a binding external constraint. It’s quite reasonable to suppose that, thanks to dependence on imported inputs and/or demand for imported consumption goods, output can’t rise without higher imports. And a country may well run out of foreign exchange before it runs out of domestic savings, finance or productive capacity. This is the idea behind multiple gap models in development economics, or balance of payments constrained growth. It also seems like the direction orthodoxy is heading in the eurozone, where competitiveness is bidding to replace inflation as the overriding concern of macro policy.

Crowding out mark six says that any increase in demand from the government sector will absorb scarce foreign exchange that will no longer be available to private sector. How relevant it is depends on how inelastic import demand is, the extent to which the country as a whole faces a binding budget or credit constraint and, what concrete form that constraint faces — what actually happens if international creditors are stiffed, or worry they might be? But the general logic is that higher spending will lead to a higher trade deficit, which at some point can no longer be financed.

So now we have six forms of crowding out:

1. Government competes with business for fixed saving.

2. Government competes with business for scarce liquidity.

3. Increased spending would lead to higher inflation.

4. Increased spending would cause the central bank to raise interest rates.

5. Overfull employment would lead to overfast wage increases.

6. Increased spending would lead to a higher trade deficit.

The next question is: Is there any reason, even in principle, to worry about any of these outcomes in the US today? We can decisively set aside the first, which is logically incoherent, and confidently set aside the second, which doesn’t fit a credit-money economy in which government liabilities are the most liquid asset. But the other four certainly could, in principle, reflect real limits on expansionary policy. The question is: In the US in 2017, are higher inflation, higher interest rates, higher wages or a weaker balance of payments position problems we need to worry about? Are they even problems at all?

First, higher inflation. This is the most natural place to look for the costs of demand pushing up against capacity limits. In some situations you’d want to ask how much inflation, exactly, would come from erring on the side of overexpansion, and how costly that higher inflation would be against the benefits of lower unemployment. But we don’t have to ask that question right now, because inflation is by conventional measures, too low; so higher inflation isn’t a cost of expansionary policy, but an additional benefit. The problem is even worse for Krugman, who has been calling for years now for a higher inflation target, usually 4 percent. You can’t support higher inflation without supporting the concrete action needed to bring it about, namely, a period of aggregate spending in excess of potential. [2] Now you might say that changing the inflation target is the responsibility of the Fed, not the fiscal authorities. But even leaving aside the question of democratic accountability, it’s hard to take this response seriously when we’ve spent the last eight years watching the Fed miss its existing target; setting a new higher target isn’t going to make a difference unless something else happens to raise demand. I just don’t see how you can write “What do we want? Four percent! When do we want it? Now!” and then turn around and object to expansionary fiscal policy on the grounds that it might be inflationary.

OK, but what if the Fed does raise rates in response to any increase in the federal budget deficit, as many observers expect? Again, if you think that more expansionary policy is otherwise desirable, it would seem that your problem here is with the Fed. But set that aside, and assume our choice is between a baseline 2018-2020, and an alternative with the same GDP but with higher budget deficits and higher interest rates. (This is the worst case for crowding out.) Which do we prefer? In the old days, the low-deficit, low-interest world would have been the only respectable choice: Private investment is obviously preferable to whatever government deficits might finance. (And to be fair, in the actual 2018-2020, they will mostly be financing high-end tax cuts.) But as Brad DeLong points out, the calculation is different today. Higher interest rates are now a blessing, not a curse, because they create more running room for the Fed to respond to a downturn. [3] In the second scenario, there will be some help from conventional monetary policy in the next recession, for whatever it’s worth; in the first scenario there will be no help at all. And one thing we’ve surely learned since 2008 is the costs of cyclical downturns are much larger than previously believed. So here again, what is traditionally considered a costs of pushing past supply constraints turns out on closer examination to be a benefit.

Third, the danger of more expansionary policy is that it will lead to a rise in the wage share. You don’t hear this one as much. I’ve suggested elsewhere that something like this may often motivate actual central bank decisions to tighten. Presumably it’s not what someone like Krugman is thinking about. But regardless of what’s in people’s heads, there’s a serious problem here for the crowding-out position. Let’s say that we believe, as both common sense and the textbooks tells us, that the rate of wage growth depends on the level of unemployment. Suppose  we define full employment in the conventional way as the level of unemployment that leads to nominal wage growth just equal to productivity growth plus the central bank’s inflation target. Then by definition, any increase in the wage share requires a period of overfull employment — of unemployment below the full employment level. This holds even if you think the labor share in the long run is entirely technologically determined. A forteori it holds if you think that the wage share is in some sense political, the result of the balance of forces between labor and capital.

Again, I’m simply baffled how someone can believe at the same time that the rising share of capital in national income is a problem, and that there is no space for expansionary policy once full employment is reached. [4] Especially since the unemployment target is missed so often from the other side. If you have periods of excessively high unemployment but no periods of excessively low unemployment, you get a kind of ratchet effect where the labor share can only go down, never up. I think this sort of cognitive dissonance happens because economics training puts aggregate demand in one box and income distribution in another. But this sort of hermetic separation isn’t really sustainable. The wage share can only be higher in the long run if there is some short-run period in which it rises.

Finally, the external constraint. It is probably true that more expansionary fiscal policy will lead to bigger trade deficits. But this only counts as crowding out if those deficits are in some sense unsustainable. Is this the case for the US? There are a lot of complexities here but the key point is that almost all our foreign liabilities (and all of the government’s) are denominated in dollars, and almost all our imports are invoiced in dollars. Personally, I think the world is still more likely to encounter a scarcity of dollar liquidity than a surfeit, so the problem of an external constraint doesn’t even arise. But let’s say I’m wrong and we get the worst-case scenario where the world is no longer willing to hold more dollar liabilities. What happens? Well, the value of the dollar falls. At a stroke, US foreign liabilities decline relative to foreign assets (which are almost all denominated in their home currencies), improving the US net international investment position; and US exports get cheaper for the rest of the world, improving US competitiveness. The problem solves itself.

Imagine a corporation with no liabilities except its stock, and that also paid all its employers and supplies in its own stock and sold its goods for its own stock. How could this business go bankrupt? Any bad news would instantly mean its debts were reduced and its goods became cheaper relative to its competitors’. The US is in a similar position internationally. And if you think that over the medium term the US should be improving its trade balance then, again, this cost of over-expansionary policy looks like a benefit — by driving down the value of the dollar, “irresponsible” policy will set the stage for a more sustainable recovery. The funny thing is that in other contexts Krugman understands this perfectly.

So as far as I can tell, even if we accept that the US economy has reached potential output/full employment, none of the costs for crossing this line are really costs today. Perhaps I’m wrong, perhaps I’m missing something. but it really is incumbent on anyone who argues there’s no space for further expansionary policy to explain what concretely would be the results of overshooting.

In short: When we ask how close the economy is to potential output, full employment or supply constraints, this is not just a factual question. We have to think carefully about what these terms mean, and whether they have the significance we’re used to in today’s conditions. This post has been more about Krugman than I intended, or than he deserves. A very large swathe of established opinion shares the view that the economy is close to potential in some sense, and that this is a serious objection to any policy that raises demand. What I’d like to ask anyone who thinks this is: Do you think higher inflation, a higher “natural” interest rate, a higher wage share or a weaker dollar would be bad things right now? And if not, what exactly is the supply constraint you are worried about?


[1] The LM in ISLM stands for liquidity-money. It’s supposed to be the combination of interest rates and output levels at which the demand for liquidity is satisfied by a given stock of money.

[2] OK, some people might say the Fed could bring about higher inflation just by announcing a different target. But they’re not who I’m arguing with here.

[3] Krugman himself says he’d “be a lot more comfortable … if interest rates were well clear of the ZLB.” How is that supposed to happen unless something else pushes demand above the full employment level at current rates?

[4] It would of course be defensible to say that the downward redistribution from lower unemployment would be outweighed by the upward redistribution from the package of tax cuts and featherbedding that delivered it. But that’s different from saying that a more expansionary stance is wrong in principle.

16 thoughts on “What Does Crowding Out Even Mean?”

  1. “1. Government competes with business for fixed saving.

    2. Government competes with business for scarce liquidity.

    3. Increased spending would lead to higher inflation.

    4. Increased spending would cause the central bank to raise interest rates.

    5. Overfull employment would lead to overfast wage increases.

    6. Increased spending would lead to a higher trade deficit.”

    Nice post.

    1 and 2 are crowding out. As in, in the hypothetical world with the weird assumptions.

    Others are not really crowding out. For example if the central bank raises rates on higher expenditure it’s not crowding out in the sense that the central bank could have chosen to not raise the rate.

    I would only use the phrase crowding out to mean government expenditure causing private expenditure to fall. Supposedly, according to neoclassical economists.

    So a interest rate hike following a large rise in say a fiscal stimulus will cause private expenditure to fall compared to the case of no hike … but compared to now is another thing.

  2. I realize I am stretching the definition a bit. What I wanted to was cover all the cases where expansionary policy would fail to raise output. That said, I do think the term crowding out is often used for case 4 as well.

  3. We may be somewhat close to average. A boom may make it easier to deal with a subsequent recession, but may also shorten the time to the next recession. Is there an alternative? There may not be, and avoiding the boom may increase the likelihood of a recession instead. It depends on how believable an interminable mediocre economy is.

  4. Very clear.

    I might have something to add, therewith deconstructing the phrase a little more.

    The example is Spain. The common story is that, before 2008, a real estate boom, enabled and partly caused by massive inflows of capital, caused high wage increases which made Spain uncompetitive which left it with a huge current account deficit.

    The part about the real estate boom and capital inflows is right. And the current account deficit was huge. Very huge. But the part about wage increases is more complicated. Considering the magnitude of the boom (remember that in some years over 50% of total net job growth in the Eurozone took place in Spain) Spanish wage increases were rather limited – as the boom was not only enabled and caused by inflows of capital but also by huge inflows of foreign labour into the construction sector as well as a rapid rise of the female participation rate. Without this inflow the construction boom would have hit a brick wall, so to speak. And without the increase in the participation rate the multiplier effects of the boom would also have caused capacity problems in the rest of the economy. At the time, everybody by the way thought that wage increases were perfectly consistent with ‘convergence’ of Spain with the northern countries. But they weren’t. Not because Spanish increases were too high. But because German increases were too low. Deliberate German government policies restricted domestic spending which led to a decline of employment and *lower* wages in many (not all) sectors. In Spain, the labour constraint was, as shown, much less binding than sometimes assumed. Your point 5. But *in combination with German policies* there were serious problems with your point 6…

    Current account deficits in Spain (and Greece, Ireland, Portugal, Cyprus, Estonia, Lithuania, Latvia, Bulgaria and a whole bunch of other countries, though not Italy) went wacko, with percentages of 15, 20 or even 25% of GDP. And, quite frightening when you think of it, this happened in only a couple of years (though we do have to concede that a country like Portugal had had deficits of over 5% of GDP for many, many years). This happened not because Spain was uncompetitive but because *total* disposable wages in Spain (employment*average wage) increased quite fast while total disposable wages in countries like Germany or the Netherlands hardly increased at all, leading to an increase in Spanish expenditure (and therewith imports) without an ofsetting increase of exports enabled by higher German spending. I.e.: a rapid increase of the labour force *as well as* lack of export opportunities (which freed resources to produce for Spanish domestic demand) mitigated any crowding out (your pints 1 to 5) potentially caused by the real estate boom – but did lead (especially in the context of the Euro) to unsustainable current account deficits.

    Now, this might officially not be called ‘crowding out’, a phrase commonly reserved to indicate the nefarious consequences of too much government spending. And this is about the nefarious consequences of private spending. But the inflow of capital, the restrictions on expenditure in Germany, the free inflow of labor in Spain were all deliberately intended by governments. Policies which, partly due to unique historical circumstances (the rise of the Spanish female participation rate)enabled that, even despite the magnitude of the boom, Spain did *not* experience serious problems with your points 1 to 5. In the end, the consequences of the increase of production were not nefarious to speak of. It did however lead to sustainability problems with 6. But the increase of Spanish output was not the unsustainable variable. The restriction of German output was. Which is a long and complicated way to state that your point 6 might well be the consequence of overly high domestic spending but it might in other situations also be the consequence of low foreign spending. this piece is an unexpectedly long and maybe arduous way to indicate that the capacities of economies to deal with ‘crowding out (even of the private kind)’ might be larger than imagined by many an economist. The concept is fuzzy, at best.

    Aside – the bust led to a decline of low productivity construction and therewith to a sudden increase of estimated average productivity of the of the Spanish economy… which also indicates that we have to be precise, when talking about the productive capacity of an economy.

    1. In my opinion, what happens is that if all countries have an high wage share, then each country can have a trade balance with said high wage share; but if each country has a low wage share, then if a country tries to keep an high wage share it becomes a net importer and loses the trade balance.

      The effect of globalization was to push each country into a low wage share policy, as each country tried to free ride the others.

      Unfortunately the sort of “protectionism” that became recently fashonable goes in the same direction, for example apparently the UK is planning to become a corporate tax haven, but can sell this to the population as an anti-EU move (via Naked Capitalism):

      Similarly the “protectionist” politic of Trump seem to be to lower corporate taxes and raise the VAT, that from a protectionist standpoint makes sense exactly because it lowers the wage share.

  5. “what actually happens if international creditors are stiffed, or worry they might be?”

    That rather depends, I would suggest, on whether they have used the ‘hard currency’ to discount their own scrip.

    Which is what you need to do to have an expanding export led economy in a floating rate system.

  6. ‘One possibility is that potential output is a hard line: each dollar of spending up to there increases real output one for one, and leaves prices unchanged; each dollar of spending above there increases prices one for one and leaves output unchanged. Alternatively, we might imagine a smooth curve where as spending increases, a higher fraction of each marginal dollar translates into higher prices rather than higher output. [2] This is certainly more realistic, but it invites the question of which point exactly on this curve we call “potential”’

    Another possibility, assuming diminishing marginal productivity of labour, is that the {conventional}, short run aggregate supply schedule, SAS(Wo), is positively sloped for a given money wage {Wo}.

    Its intersection with the ADp schedule {the relationship between P and Y}, determines the initial level of output/income, Yo.
    At the intersection of ADpo and SAS(Wo), on SAS(Wo), the mpl(No) is equal to Wo/Po. The ‘profit maximising’ condition. No labour employed produces Yo income/output.

    To affect Yo, any increase in aggregate demand will, initially, have to, and will, increase the price level. {At Po, there will be an excess demand for Y}.
    Assuming a given money wage (Wo), this will lead to a fall in the real wage. Now mpl(No) > Wo/P1.
    It is profitable to employ more labor and produce more Y, say Yf.

    Once Yf is reached any increase in AD will lead to a greater increase in P.

    How do ‘we’ know if the economy is at its potential, Yf?

    The Bank of England ‘target’ is 2% inflation.
    If inflation is above 2% and is expected to remain above 2%, and possibly increase, {ADp > Yf} {AD is above potential} then monetary policy will be tightened.

    If inflation is below 2% and is expected to remain below 2% {ADp < Yf} {Y is below potential} then monetary policy will be slackened.

    The inflation rate will indicate the relationship between AD and Yf and the necessary policy measures that need to be implemented?

    1. I’m afraid I find this a little hard to follow. But it sounds like a version of the conventional story — output and inflation are positively related, and potential output is just the level of output consistent with the central bank’s inflation target. How is this different from what I wrote?

      (You do have Friedman notion that higher inflation boosts output because it tricks workers into accepting a lower real wage. But I don’t see how that matters for the question here.)

  7. Hyman Minsky has a chapter on inflation in Stabilizing an Unstable Economy. I think he uses a dynamic model for an economy that shifts the labor pool from production of consumption goods to production of investments goods. As I recall this shift would cause inflation in the prices of consumption goods. I also recall that he thought a stable economy would have private investment and government spending at about the same magnitude, so that the government could use counter cyclical spending to compensate for the investment cycle, and that consumption should be a rather high percentage of the domestic economy. Emerging growth economies should have a relatively high share of investment and probably higher interest rates. Mature or what I call “saturated” economies seem to have a higher share of consumption and lower interest rates. I don’t recall his ideas regarding crowding out.

    I intend to share the link to this excellent article with the Understanding Money group.

  8. Thank you for a v helpful post. Would not 5 (the Phillips curve story) go better at 4, so that it would sit after the postwar macro ‘inflation trade off’ story as the ‘vertical’ Phillips curve and so set the scene for the new consensus central bank reaction function stuff?

    1. Yes, you’re probably right. A version of this post will be part of the paper i’m writing for the Roosevelt Institute on potential output; I think there I’ll switch them as you suggest.

  9. Just addressing 1 and 2, which Ramanan rightly highlights as the most common, straightforward meanings of “crowding out.”

    I think you’re too generous to those notions by half. They assume that a higher saving rate somehow creates a greater “supply” of “savings.” Whatever those mean.

    This notion lurks at the core of these crowding-out ideas, the whole Solow growth model, IS/LM, the whole lot.

    If we’re talking about some kind of (inevitably monetary) “funds,” some stock of monetary “savings,” this must mean balance-sheet assets. And neither spending (which is just transferring assets between balance sheets) nor monetary saving (not transferring assets) can change the total stock of assets available to “fund” investment/lending.

    Monetary saving, in aggregate, does not create more monetary “savings.” A huge error of composition at the heart of almost all macro.

    Goods production (including output-greater-than-input surplus), if it exceeds consumption, accumulates valuable goods. But it does not create new aggregate balance-sheet assets.

    In response to that ongoing real-goods accumulation, the government-financial system creates new balance-sheet assets (ownership claims on those additional accumulated real goods) — through the mechanisms of gov def spending, private-sector lending, (trade imbalance,) and capital gains.

    Those purely monetary/asset mechanisms arguably increase the aggregate “supply” of something we might call loanable funds — balance-sheet assets. Or just, wealth. Monetary saving (not-spending) by HHs, the income-minus-expenditures mechanism depicted in the “saving rate,” in aggregate does not and cannot increase that stock.

    Absent any such accounting-coherent notion of the so-called “supply” of “savings,” #s 1 and 2 are gobbledygook from the get-go.


    1. “Goods production (including output-greater-than-input surplus), if it exceeds consumption, accumulates valuable goods. But it does not create new aggregate balance-sheet assets.” [Steve Roth]

      I don’t think that this is true: if one produces, say, more iPhones than are consumed, he ends up with a lot of unsellable iPhones, not with savings.

      I think that either savings are tought as credit, aka someones else’s debt (hence there are no “real savings”), or they can be seen as the counterpart of some capital assets (then we could have some savings that are “real”, that is they are covered by some capital asset, and some that are not, this is the Austian theory of crises AFAICT), or some speculative goods that react in terms of price and not in terms of quantity to demand (so that high savings/wealth just mean an higer price for the same land, not a “real” saving).

      The point is that in a market system nobody ever saves anything “real”, all that is not used is lost, the closest thing to actual saving is investiment but we can’t assume that to a certain quantity of “savings” (credit) always corresponds an equal amount of investiment/capital assets.

      In my view we should not speak of “savings” but differentiate between “credit” (that is always the counterpart of someone else’s debt) and the assets that might/might not back this credit. These should then be differentiated in “true capital” (produced means of production, aka factories, that respond to demand in terms of quantity) and speculative assets (like land but also other immaterial assets, that respond to demand in terms of price).

      Also, I think that option “2” (and the notion of a quantity of money in general) is a nonsense even in a pure “gold coin” system: if there was a certain fixed quantity of money, in case of a recession (when the quantity of working people shrinks and real GDP shrinks) there should be inflation: same money for less stuff. But for all that I know recessions were deflationary even during the gold standard era.

  10. “Suppose the amount of money-spending in an economy increases. Then either the quantity of goods and services increases, or their prices do. There is no third option..”

    Following on from Merijn’s example above, is there not a third option of shifting the boundary between the monetary and non-monetary sectors? As in drawing in household labour, or monetising off-market services (childcare? Old age care? Home maintenance? Parking meters as in Chicago…).

    Empirically, there does not seem to be a straightforward or mechanical relation between inflation and monetary supply – indeed it is difficult to find a straightforward measure of either.

    1. For economics, it really makes no difference if we think of an increase in market production as being new stuff in some absolute stuff, or the replacement of non-market activity with stuff produced for sale.

      there does not seem to be a straightforward or mechanical relation between inflation and monetary supply – indeed it is difficult to find a straightforward measure of either.

      Agree completely. I think we can throw out the idea of a “money supply” entirely. Whether we can also get rid of the idea of a (measurable) rate of inflation I’m not so sure. It’s worth noting that Keynes thought we were better off without it. That’s why the GT is written, confusing to modern eyes, in terms of “wage units.”

  11. Merijn-

    Thanks for the comment, and sorry for the slow response.

    I agree with you 100%. The narratives about European imbalances – both those that blame Germany and those that blame Spain/Greece/etc. – have overemphasized relative prices. The opening and more recent closing of intra-European trade deficits is fully explained by different rates of income growth — my friend Enno’s work, which i’ve mentioned before, makes this point very clearly.


    Just addressing 1 and 2, which Ramanan rightly highlights as the most common, straightforward meanings of “crowding out.” I think you’re too generous to those notions by half. They assume that a higher saving rate somehow creates a greater “supply” of “savings.”

    I don’t think I’m that generous to the first one, given that I say that it’s logically incoherent! And for exactly the reasons you give.

    As for 2 — I wouldn’t say that a Hicks-style story of scarce outside money, which has to be held in lower proportion to income as income rises, is gobbldygook. I just don’t think it has anything to do with the kind of economy we live in.

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