Key economic policy organisations still claim that public spending undermines private spending

It is hard to imagine that so little progress has been made in dismantling the mainstream macroeconomics paradigm over the last decade within the institutions of government. We have had the GFC, and now, the pandemic to disclose what does and does not happen when governments engage in relatively large fiscal shifts, yet the fictional world that is taught in mainstream university programs and echoed in policy making circles keeps being rehearsed. While researching the literature on rates of return on public infrastructure spending for a project (book chapter) I am working on at present, I came across the starkness of the mainstream deception. They are still claiming that public spending damages private spending.

On June 16, 2016, the US Congressional Budget Office released a report – The Macroeconomic and Budgetary Effects of Federal Investment – which purported to show that “Federal investment in physical capital, education, and research and development boosts private-sector productivity gradually” but reduces funds available for private investment.

It also claimed that “federal investment ultimately yields a return that is one-half as large as the return on the average private-sector investment.”

I searched the document for references that were cited to give authority to this assertion.

The earlier literature that I am familiar with found almost exactly the opposite outcomes and one of the recent papers cited by the CBO, came up with results that seem contrary to CBO’s interpretation.

Further, there was no evidence to support the principle finding that:

Increased federal borrowing reduces the amount of money available for private investment … CBO’s central estimate is that for each dollar that the federal deficit increases, domestic private investment falls by 33 cents. That reduction in private investment results in a smaller capital stock, eventually shrinking output.

Another assertion based on their internal modelling, which is constructed to deliver that result.


The CBO lives in a parallel universe

The CBO basically lives in a fictional world and it is little wonder that the advice being given to the US government is so defective.

The early work on this subject came from David Aschauer in seminal papers published while he worked at the Federal Reserve Bank in Chicago.

1. Aschauer, D. (1989a) ‘Is Public Expenditure Productive?’, Journal of Monetary Economics, 23 (2), 177-200.

2. Aschauer, D. (1989b) ‘Does public capital crowd out private capital?’, Journal of Monetary Economics, 24 (2), 171-188.

As an aside, David Aschauer drowned while smimming in a triathlon in the US in 2011.

These papers really put the ‘cat among the pigeons’ because they challenged the basic ideas that mainstream macroeconomics is built on – that government spending on infrastructure – roads, bridges, airports – undermines private investment spending (crowding out) and undermines productivity growth.

David Aschauer was motivated by the empirical reality that the strong public infrastructure spending in the 1950s and 1960s was associated with strong growth in overall productivity, and, when public investment started to decline in the 1980s as the neoliberal attacks on fiscal intervention increased and became dominant, productivity growth started to decline as well.

His deep econometric modelling established what he considered to be a causal relationship between increased public spending and enhanced output and productivity growth, and, importantly, he found that public expenditure on infrastructure actually ‘crowded-in’ private investment.

In other words, the two types of investment spending – public and private – were complements rather than competitors.

His results suggested that the rate of return on public infrastructure investment was around three times higher than the return on private capital formation.

A shocking result for the mainstream contention, that organisations like the CBO still like to deny (as above).

There were several supportive research articles published after this seminal work that all supported the result.

For example:

1. Munnell, A.H. (1990) ‘Why Has Productivity Growth Declined? Productivity and Public Investment’, New England Economic Review, Federal Reserve Bank of Boston, January/February, 3-22.

2. Lynde, C. and Richmond, J. (1992) ‘The Role of Public Capital in Production’, Review of Economics and Statistics, 74 (1), 37-44.

3. Lynde, C. and Richmond, J. (1993) ‘Public Capital and Total Factor Productivity’, International Economic Review, 34 (2), 401-14.

Of course, the attacks dogs went to work and several papers came out criticising the econometric approach that David Aschauer had used.

I won’t go into the technical details but for those who are interested in these things the criticisms centred on issues of simultaneity (in other words, the relationships found were not real and were driven by a trend in all similar variables) and causality (in other words, what causes what – that output growth drives public expenditure growth rather than the other way round).

A more recent study in 2010 by James Heintz used up-to-date techniques, which resolved any of the econometric issues in the earlier studies and found that David Aschauer’s early work was meritorious.

There was indeed a strong positive impact on private productivity growth arising from increased public infrastructure expenditure, which once again destroys the sort of estimates that organisations such as the CBO pumps out.

Reference: Heintz, J. (2010) ‘The Impact of Public Capital on the U.S. Private Economy: New Evidence and Analysis’, International Review of Applied Economics, 24 (5), 619-32.

Some simple calculations using the estimates provided by the work of Heintz would suggest that the rate of return on public investment in terms of extra GDP is somewhere between 30 and 40 per cent.

Later, a ‘meta study’ from two European-based researchers Pedro Bom and Jenny Ligthart – What Have We Learned from Three Decades of Research on the Productivity of Public Capital – (published in 2014 in the Journal of Economic Surveys, 28 (5), 889-916) – confirmed several important results, that were applicable to all economies.

Effectively, ‘meta analysis’ seeks to resolve the differences across many studies by deploying “statistical methods to summarize, evaluate, andanalyze empirical results across studies; it presents a systematic and objective way to explain and control for the study-to-study variation.”

They investigate 578 instances where researchers have studied the relationship between public infrastructure spending and GDP growth.

Their final estimates are below those derived from David Aschauer’s initial work but still strongly positive.

For example, they find a return on public capital infrastructure (depreciation adjusted) of around 14 per cent, which increases when ‘regional’ capital spending (state/local government) is considered.

The regional estimates are subject to downward bias because of the interregional ‘spillover effects’, where investment in one region/state has productive impacts on neighbouring regions/states (perhaps due to a new bridge, road network etc).

The ‘meta study’ isolated 31 separate US-focused research projects in this field and determined that the average return on public investment was high and much larger than the CBO claimed in the paper cited above.

The CBO estimated that the private rate of return is 10 per cent (“that a $1 increase in private investment, all else being equal, increases output by 10 cents over a year”) and “the average rate of return on federal investment … is about 5 percent.”

The CBO use the Bom/Ligthart paper as an authority although they came up estimates of the relationship between public infrastructure spending and output that was twice as large as the estimate CBO base their own work on, which is how they get the 5 per cent rate of return estimate.

While the CBO claim that their “judgement” is “consistent with the range of estimates found in the research literature”, I would disagree. Their estimates are well below what most researchers in the area would think reasonable.

So my reading of the literature, contrary to the CBO’s conclusion, is that the best research results we have at present indicate that there are strong gains arising from government infrastructure spending.

Why ‘financing’ doesn’t matter

The CBO claim that their estimates are conditional on the ‘financing’ methods for the government spending increase.

They analyse two cases: “reducing other spending and increasing federal borrowing”.

The first option is considered the best return on the infrastructure spending because they assume that cutting other public spending to create the offset has no negative consequences for output growth.

The borrowing option sees the CBO wheel out the fiction plus.

They say:

… the increase in federal borrowing would reduce the amount of money available for private investment, damping GDP in later years.

The CBO identify two negative impacts:

1. “the Federal Reserve, in CBO’s view, would respond by raising short-term interest rates to prevent inflation from rising above the central bank’s longer-term goal.”

2. “increased borrowing would reduce the amount of money available for private investment, thereby heightening competition for investors’ money.”

Clearly, this report pre-dated the massive shift in Federal Reserve thinking in August 2020, where they abandoned the NAIRU approach – the forward-looking hike rates to suppress the possibility of inflation – in favour of a backward-looking approach, to wait until inflation was entrenched in their ‘targetting’ range (even though they haven’t an explicit range) before acting on rates.

That shift in Federal Reserve thinking has been significant and explains why interest rates have not been rising quickly in the US, in response to the supply-side induced inflation spike over the last several months.

Mainstream economists teach that when national governments run deficits and issue debt, they crowd out private spending.

The assertion is a central part of the mainstream attack on government fiscal intervention.

At the heart of this conception is the Classical Loanable Funds Theory, which creates a fictional rendition of the way financial markets work.

For our purposes, the crowding out hypothesis is based on the claim that at any point in time, there is a limited supply of private sector saving for which government borrowing and private sector borrowing compete.

If government tries to borrow more, by issuing and selling more bonds, then the competition for finance would push up interest rates as the demand for saving rises relative to a scarce supply.

The upshot is that some private firms would then find that the higher borrowing rates render their investment projects unprofitable and so private investment expenditure falls.

They also claim that private investment spending is always more productive and desirable (because firms have to face the market test to survive) than government spending, which is characterised as being relatively wasteful because there are no shareholders to ‘keep government honest’.

A careful understanding of what drives saving and how banks actually operate shows that the basic crowding out hypothesis is inapplicable in modern monetary systems.

First, government deficits stimulate sales, which leads to higher GDP (income). As a result, the pool of savings expands because saving is a function of GDP (income).

The Italian economist Luigi Pasinetti once noted that “investment brings forth its own saving” – an astute observation that applies to all spending sources.

The other way of understanding this is that government deficits generate non-government surpluses that accumulate to increased wealth holdings in the non-government sector.

Since there are more savings and greater financial wealth, government borrowing does not reduce the pool of funds available to private sector borrowers.

Quite the contrary.

Second, if we examine the way modern banks operate, it further becomes obvious that the crowding out conjecture does not apply to the real world.

Students in mainstream banking courses are told that commercial bank lending is reserve constrained.

That is, banks are considered to solicit deposits from lenders, which then allows them to build up reserves that they can then loan out.

But in the real world, bank loans are not reserve-constrained.

Banks do not just sit around waiting to dollop out their current deposits to lenders in some sort of rationing plan.

Banks solicit credit-worthy borrowers to extend loans to. Importantly this means that loans create deposits, not the other way round.

So, there can never be ‘financial crowding out’ in a modern monetary economy.

Fiscal deficits do not reduce the capacity of private borrowers to access funds in the financial markets.


Organisations such as the CBO continue to run the mainstream line and influence government policy adversely, as a consequence. While the report analysed here was written in 2016, more recent material published by the CBO reveals they are still pushing the line that public spending damages private spending.

It remains a long haul to change this institutional inertia.

Our edX MOOC – Modern Monetary Theory: Economics for the 21st Century continues

We are off and running again for another year with the first day of our MMTed/University of Newcastle MOOC – Modern Monetary Theory: Economics for the 21st Century.

The course is free and will run for 4-weeks with new material each Wednesday for the duration.

It is not to late to enrol and became part of the already large class.

Learn about MMT properly with lots of videos, discussion, and more.

This year there will be some live interactive events offered to participants, which adds to the material presented previously.

So even if you completed the course last year, these live events might be a reason for doing it again.

Further Details:

If you want to do the course, get in early as then you avoid having to catch up.

All are welcome.

That is enough for today!

(c) Copyright 2022 William Mitchell. All Rights Reserved.

This Post Has 10 Comments

  1. I’ve written to the CBO to explain their error on “crowding out”. In response, I get form letters not addressing my points but instead telling me they consult all the experts and have everything under control. In other words “please go away”.

    Another direct way to address the issue (on their own terms) is to explain that net financial saving = zero, an identity. That is, for every new financial asset, there is an offsetting liability. Or you can note that all spending = all income. Since financial saving = income minus spending, net financial saving must be zero.

    To use their language, it the government runs a deficit of $1T, it is dissaving by $1T. Since total financial saving = zero, then the private sector must run a surplus of $1T – an MMT principle.

    Point being that total financial saving – public plus private (using their framework) is unchanged. Therefore, investment must be unchanged as well- no crowding out.

    The CBO, of course, does not respond to such logic.

  2. When Portugal declared the end of slavery, capitalists found a way to turn free people into slaves.
    You might call it serfdom, but it all adds up to keeping workers tied up with a debt they can’t pay.
    Back then, it was the land, the house, everything they needed to live, but everything belonged to the boss, from the day they were born to the day they died.
    Financialization in exactly what serfdom is all about and it’s what we are driving the world to.
    They even found a way to turn entire coutries into serfdom in a snap.
    With the onset of the euro, banking activity was deregulated in most of europe.
    For 10 years, banking became a casino.
    In 2010, bankrupcy was the outcome.
    Several banks failed.
    All that defaulted debt (25 bilion € of it) was nationalized, pushing the public debt from around 75% of GDP to 130%.
    Ever since, the liberal-socialist government that ruled back in 2010, has been accused of profligacy, that the spending it did in previous years, drove the country to bankrupcy.
    It’s false, everybody knows it, but all their program depends on it.
    The mainstream narratives are exactly the same thing.
    And they keep their power because the media has a commitment to push those narratives.
    Let me give an example.
    In a recent debate on the portuguese public tv broadcaster, some days ago, they called 3 mainstream economists and 1 keynesian economist to talk about macro-economics.
    One of the mainstreamers left the technical stuff and ushered into ideological mumbo jumbo; the keynesian replied immediatly, just to be atacked by another of the mainstreamers of beeing Marxist.
    The 3 mainstreamers enjoyed the victory, because the keynesian opinion IS the minority.

  3. Somebody said ” building the economic infrastructure is the job of government not the non-government”. That is made much easier if a government issues its own sovereign currency and mandates taxation to give that currency value. The latter can be created and spent by a government to the limit that it makes the best use of the human and natural resources available in its economy, without over-revving the engine into the red zone of inflation. The beauty of that sovereign currency is it costs the government nothing. It does not have to borrow it new or second-hand from holders; nor does it have to, but it can, offer interest to holders of its previously spent currency.

    Vertical money and Horizontal credit need some illumination by MMTers. The latter, in the non-government sector, works with balance sheets; assets equal liabilities and the whole lot sums to zero. The vertical sovereign currency “money”, works with an unbalance sheet, mostly in deficit waiting for the taxation mechanism to return the money and reduce the unbalance (deficit).

    There is interaction between the horizontal and the vertical. For instance. When the government pays my state pension into my current account at my High Street Bank, it pays the the same amount into my bank’s reserve account at the BoE. My Bank’s balance sheet continues to balance. I then transfer my pension to an account at another, different brand of Bank. At the end of the day the BoE transfers the reserve that matches my pension, from my Bank to the different Bank. Both Banks balance sheets continue to balance.

    The bottom line is nobody crowded out anybody; in fact, as Prof Mitchell says, the government’s infrastructure spending allows the non-government sector to pile in and take advantage of that infrastructure in multiple ways.

  4. The loanable funds fallacy and its “crowding out” cousin are two of the most pernicious and persistent zombie concepts that still roam the public discourse to considerable ill effect. Only the atrocious household budget analogy is worse.

  5. The CBO explains the logic of crowding out as follows – from their own material:

    “When the government borrows, it borrows from households and businesses whose saving would otherwise be financing private investment. Although an increase in government borrowing strengthens people’s incentive to save, the additional saving by households and businesses is less than the increase in borrowing. The result is not only reduced private investment but also lower economic output and national saving.”

    The CBO is pointing out that the recipients of a “deficit payment” (from higher spending or lower taxes) will typically spend, not save, much of the payment. This partial saving by the recipients will therefore not fully offset the saving that was borrowed from the private sector to buy the securities that were issued. Therefore, the result is an overall reduction in non-Treasury saving which will lead to lower investment as well.

    However, assume the government borrows from private sector Agent A. This money is then given to private sector Agent B, the beneficiary of the higher spending or lower taxes. As the CBO explains, Agent B will typically spend much of this money- reducing Agent B’s saving. However, the CBO is overlooking that when Agent B does spend the money, a private Agent C will receive the money. Agent C will elect to save or spend – usually some combination. If Agent C saves, it is saving. If Agent C spends, the money is now Agent D’s saving and so on. Each entity in this chain will either save or spend until the money is all saved. Money is not consumed. It just changes hands.

    An easy way to understand: Note that when Agent B originally received the money, at that moment, it was all saving for Agent B. All subsequent transactions result in one bank account debit and one bank account credit -leaving the amount of money (saving) in the system unchanged.

    From a macroeconomic perspective, this additional saving in the system becomes the offset to the saving which was originally used by Agent A to purchase the Treasury securities. Hence, non-Treasury saving is unchanged and crowding out does not occur. And Agent A now owns Treasury securities which represents an overall increase in private sector saving – the necessary accounting offset to the government’s dissaving.

    In sum, the CBO (and most economists) have overlooked that there are two sides to every transaction. A deficit financed payment to the private sector must end up fully as private sector financial saving, regardless of what the original recipient of the payment does with the money.

    I have found they have no interest in understanding the hole in their logic.

  6. The second assignment I had as (mature) undergrad was an essay about ‘crowding out’. I knew it was fallacious, but made a hash of it (after getting good mark for first – actually about housing, although I didn’t understand that either back then). If only I’d known …

  7. Look, Federal “borrowing” is nothing more than ex nihilo creation of future money in the form of Treasury bonds. It won’t “crowd out” anything.

  8. Completely believe mmt.
    Yet if banks do not have surplus reserves, how are new loans possible?
    Unless govt spends afresh and/or central banks add reserves.
    Govts and central banks alone create/shrink reserves.

  9. @recneps

    Banks create loans endogenously. They only need a credit worthy customer and a banking licence.

    The bank makes two simultaneous transactions, a credit to the value of the loan on the asset side of their balance sheet, and a corresponding debit on the liability side, i.e. your bank account. This sums to zero, and so satisfies accounting rules.

    Therefore loans create deposits

    The bank only needs reserves when you spend your deposit, which it normally borrows from banks with surplus reserves when the banks settle up at the end of the day.

  10. @recneps When a bank finds a qualified borrower it makes the loan and creates a deposit. If the bank is subsequently short of reserves, it will seek to borrow reserves short term elsewhere in the banking system. If the banking system as a whole finds itself becoming short on reserves, the prevailing interbank rate will rise, perhaps above the Central Bank’s target. The Central Bank will respond to the interbank rate exceeding its target by buying assets from the banking system, paying for those assets with newly created reserves. By this mechanism, the supply of reserves always meets demand for credit at the Central Bank’s target interbank interest rate.

Leave a Reply

Your email address will not be published. Required fields are marked *

Back To Top