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October 26th 2009 print

Peter Smith

A modern fairy tale

It seems as though there is a magic pudding. The Government can apparently spend big and borrow very large sums to pay for it without ever having to worry about its effect on interest rates. This seems to be too good to be true; and so it is.

Government borrowing and crowding out 

One of the principal points made by those economists who think stimulus spending is counterproductive is that the resultant government borrowing will crowd out private sector borrowing. The analysis underlying this point is simple enough. Government borrowing will increase interest rates, particularly long-term interest rates, and will therefore make it more expensive for businesses to borrow. 

Enter Reserve Bank Governor Glen Stevens, and other less prominent economists and economic commentators, who effectively seem to be saying that crowding will not occur to any great extent because the borrowing market is global. 

When appearing before the Senate Economics Reference Committee on 28 September 2009, Stevens was asked this question by Senator Ryan:

The Government is undertaking substantial borrowings…do you believe there is a risk of crowding out the private sector… 

He answered as follows:

… there is some potential for that risk … The question really is, quantitatively, how big it is. My point is that the thing which is most likely to crowd out Australian businesses and other businesses by pushing up the long-term global interest rate … is not going to be the Australian government’s borrowing, unless it is a lot bigger than it looks like being – it will be the huge run up in public debt in the major countries, which are quantitatively so much larger. 

The message from this is that because borrowing is now global and Australia is a relatively small player, what we do, within broad limits, will have no material effect on global interest rates and therefore on the rates Australian businesses have to pay. 

It seems as though there is a magic pudding of sorts after all. The Government can apparently spend big and borrow very large sums to pay for it without ever having to worry about its effect on interest rates. This seems to be too good to be true; and so it is, because it ignores the use made of the borrowings and the foreign exchange effects while, at the same time, paying no heed to the fact that most small and medium sized businesses borrow domestically. It is at best partially true; while the whole truth tells a different story. 

The partial truth is that the borrowing itself does not result in crowding out. For example, the government could borrow globally invest the money in a balanced range of overseas and Australian financial assets and have no crowding out effect. But the government is not doing that, it is spending the money on things like school buildings, on ceiling insulation and on boosting consumption expenditure, and is therefore crowding out private expenditure by its borrowing. 

One way to explain this is to imagine an Australia that could go on a continual borrowing binge without affecting domestic interest rates or crowding out any competing business investments. In this Australia, all of the competing investments would provide a profitable return so that any borrowing from domestic or overseas sources could be repaid easily. Resources of all kinds would flow in freely and sufficiently to relieve bottlenecks and any pressure on inflation. Inflation would be countered also by the rising exchange rate, reflecting the profitability of the business investments being undertaken. Of course, Australia is not like that; nor is anywhere else. 

Government borrowing has a counterpart in spending which uses up domestic resources and contributes to inflation and therefore to rising domestic interest rates. Rising domestic interest rates increase the borrowing costs of most small to medium sized businesses. It is ironical that the Reserve Bank is on course of increasing interest rates while, at the same time, saying that government borrowing has little or no effect. What borrowing and spending does then have the effect of causing the Reserve Bank to raise rates? 

The crowding out effect needs still more fleshing out because borrowing for unproductive purposes will tend to have more of a crowding out effect than borrowing for productive purposes (i.e., for purposes which earn an economic return). Borrowing for productive purposes provides the wherewithal to attract overseas resources to partially relieve bottlenecks. It also tends to underpin the exchange rate which, in turn, keeps inflation lower than it would be otherwise. Borrowing for unproductive purposes (e.g., to boost consumption expenditure or to build school halls) eventually puts downward pressure on the exchange rate because it generates no earnings to pay back the global borrowings. This results in additional pressure on the exchange rate, and upward pressure on inflation, which means that domestic interest rates have to be higher than would otherwise be the case. 

As noted, higher domestic interest rates particularly impact small and medium sized businesses, but large businesses that borrow globally do not remain unscathed. Their global interest rates may not change, but the effect of unproductive government borrowing in lowering the exchange rate (below what it would otherwise have been) will increase their debt servicing costs in Australian dollars. So they too will face higher effective interest rates. This proves once again that there is no such thing as a free lunch and that crowding out is alive and well.

Peter Smith, a frequent Quadrant Online contributor, is the author of Bad Economics