The crowding-out effect occurs when the government’s active involvement in the economy affects the market and private companies’ spending by interfering with the private sector’s financial climate. Concerning the reasons, the crowding-out effect typically takes place because of increases in interest rates resulting from the growth of government spending.
Crowding out is a well-studied economic phenomenon that sheds light on governments’ ability to influence markets. The situation in which the effect takes place as a result of adherence to expansionary fiscal strategies is among the most well-known cases and types of crowding out. Fiscal crowding-out, as Spencer and Yohe argue, can undermine the success of economic stabilization efforts.
To start with, expansionary policies implemented by governments are aimed at boosting economic development and business investment by providing businesses with more financial resources. It should come as no surprise that when any government increases spending to promote development and growth, it starts to put more resources into the economy than it receives. This situation may lead to budget deficits that require increases in borrowing to be financed.
As the rates of borrowing experience continuous growth, the government is required to spend more to make the necessary payments to those lending it money. Facing the need to borrow much more money, governments may contribute to interest-rates spikes. In its turn, the growth of interest rates affects privately-owned companies’ financial decision-making.
In particular, higher interest rates make borrowing more costly, and it inevitably decreases private companies’ motivation to borrow funds because of risks associated with financial solvency. In this challenging situation, businesses and organizations in the private sector regard reductions in spending as a viable option allowing them to maintain financial stability. As a result, companies in the private sector become less involved in a country’s economic life, which is the essence of the crowding-out effect.