Crowding Out Effect

In economics, crowding out theoretically occurs when the government expands its borrowing more to finance increased expenditure or tax cuts in excess of revenue (i.e., is engaged in deficit spending) crowding out private sector investment by way of higher interest rates. It represents one of the major controversies in modern Macroeconomics.

Since increased borrowing leads to higher interest rates by creating a greater demand for money and hence a higher "price" (ceteris paribus), the private sector, which is sensitive to interest rates will likely reduce investment due to a lower rate of return. This is the investment that is crowded out. The weakening of fixed investment and other interest-sensitive expenditure counteracts to varying extents the expansionary effect of government deficits. More importantly, a fall in fixed investment by business can hurt long-term economic growth of the supply side, i.e., the growth of potential output.

However, this crowding-out effect is moderated by the fact that government spending expands the market for private-sector products and thus stimulates – or "crowds in" – fixed investment (via the "accelerator effect"). This accelerator effect is most important when business suffers from unused industrial capacity, i.e., during a serious recession or a depression.

Crowding out can, in principle, be avoided if the deficit is financed by simply printing money, but this quickly leads to hyperinflation as seen in Germany in the period between WWI and WWII,
or in Brazil before the introduction of the real.

The negative effects on long-term economic growth that occur when private fixed investment are crowded out can be moderated if the government uses its deficit to finance productive investment in education, basic research, at the like. The situation is made worse, of course, if the government wastes borrowed money on such things as "pork belly" projects and tax cuts for the political allies of the current politicians.(From Wikipedia, accessed Feb 13th)