Opinion Articles

Crowding out

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All major economic crises in twentieth century Britain have reignited simmering debates about the impact of public sector expansion on economic performance. From the 'Geddes Axe' after the First World War, through Keynes' attack on the 'Treasury View' in the interwar years, down to the 'monetarist' assaults on the public sector of the 1970s and 1980s, it has been alleged that public sector growth in itself, but especially if funded by state borrowing, has detrimental effects on the national economy. This argument has been once again in play in the current recession. In June 2010 the Chancellor, George Osborne, spoke of public spending 'crowding-out private endeavour' and in more dramatic vein, a recent Channel 4 programme represented Britain's public sector as a 'Trillion Pound Horror Story'.

A historical perspective to this debate about crowding-out needs to recognise the longevity of the arguments, but is perhaps best pursued by focusing on the 1970s, when the term was at the centre of the political argument. Interestingly, the most immediately politically influential advocates of the crowding-out thesis in these years were not 'monetarist' economists focusing on macroeconomics and short-run fiscal and monetary policy, but Roger Bacon and Walter Eltis who in their book Too Few Producers drew on essentially eighteenth century notions of 'productive' and 'unproductive' labour to allege that Britain's economy was being strangled by public sector growth. Their book appeared in 1976 when alongside the famous fiscal crisis of that year, there was growing concern with the longer-term issue of de-industrialisation. Bacon and Eltis argued that de-industrialisation was the result of the rapid growth of public sector 'non-marketed' output depriving the manufacturing sector of both labour and investment resources. Especially striking about their argument was that it made no bones about assuming that anything done by the public sector where there was no market was necessarily less desirable than private sector activity.

The theoretical and empirical problems of this version of crowding out were clearly recognised at the time. Theoretically, it was very difficult to see why, say, educational provision by the state was necessarily less efficient than exactly the same provision made through the private sector. Empirically, the idea that public sector growth had been at the expense of private sector investment was not supported by the data, which suggested the rising taxes of the 1960s and 1970s had been at the expense of private consumption, not private investment. In addition, the idea that de-industrialisation was caused by workers being denied to industry by being drawn into the public sector seemed wholly at odds with an overall rise in unemployment levels evident from the late 1960s.

While novel in some respects, in many ways Bacon and Eltis's thesis underpinned a crude 'private sector good, public sector bad' ideology. This crudity tended to itself 'crowd-out' more sophisticated arguments, prominent in the 1960s, which tried to assess the social rate of return on investment. In this approach, the public versus private sector dichotomy was set aside, and an attempt made to see how far the returns on characteristic public sector investments such as transport and communications, but also education and health, can, if appropriately computed, match those in the private sector. These assessments tended to get sidelined in the Manichean debate over the size of the public sector and the scale of 'unproductive' expenditure. Such assessments were especially subversive of the idea that the public sector is a 'burden' on the private sector, because they suggested that much public sector investment could be seen as providing the necessary conditions for the private sector to function effectively. This positive relationship between public and private sector is often implicitly recognised when bodies like the CBI complain about poor infrastructure or inadequate education, but tends to be ignored in the wider ideological debates.

In the 1970s allegations of crowding-out were also made by a range of macroeconomists and commentators in relation to the fast rise in public borrowing in the first half of that decade. This was financial crowding-out, rather than the resource crowding-out of Bacon and Eltis. At its simplest, this argument suggested that large- scale public borrowing raised interest rates and in so doing increased the costs of borrowing by the private sector and thereby reduced private investment. In part such arguments mirrored Bacon and Eltis in assuming that private sector investment is always to be preferred to that in the public sector - after all, in this simple model, all borrowing raises interest rates, so why should we deem public sector borrowing more of a problem than that by the private sector unless we have an a priori belief that 'private sector good, public sector bad'?

Financial crowding-out was debated very widely in the 1970s, but for the historian one feature is striking. The simple model on which much of the debate depended assumed a fixed supply of savings, for which public and private sector competed, hence driving up interest rates. Yet, paradoxically, the 1970s was the decade of great strides towards free international movement of capital, so that the pool of resources available to a country like Britain was no longer restricted by national boundaries. Governments and the private sector could freely borrow in international markets and for a small country like Britain borrowings were such a limited proportion of the total world supply that they would have no impact on interest rates. This point came to be recognised in the debates of the 1970s, but its paradoxical implications remain hugely important today.

On the one hand, international capital mobility completely undermines a simple model of crowding-out in a closed national economy, where the public sector's borrowings, if substantial, raise interest rates against the private sector. However, this availability of funds from across the globe means that borrowing is reliant on international credibility and 'confidence', which can provide a much more powerful constraint on public borrowing than allegations of crowding-out. In 1976 this was very evident in the 'gilt-strike', when financial markets simply refused to buy government debt until, in their view, the government had 'put its house in order'. This, of course, is exactly where we are today, with international financial markets acting as the key players in determining what is an 'acceptable' level of public borrowing. Allegations of 'crowding-out' may be largely ideological, and refutable from historical evidence, but the need for 'credibility' is a much more powerful (though not all-powerful) constraint on governments.

Please note: Views expressed are those of the author.


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