The crowding out effect

-This article was published by Ashesh Shrestha in The Himalayan Times on July 31, 2016.

Of late, the fiscal budget of Nepal has been growing at an alarming rate — about 27 per cent in the fiscal year 13/ 14; 19.5 per cent in 14/ 15; almost 33 per cent in 15/ 16. As the trend continues, the size of the budget has increased by more than two trillion rupees ( 28 per cent) with the total estimated outlay reaching an all- time high of 10.5 trillion rupees ( which is about half of the GDP of Nepal).

Such high levels of government spending can have many adverse effects on the economy. One of them is the negative impact on private investment. Here we specifically focus on the undesirable effect of high public spending on private sector investment.

Crowding out effect

Economists come to a mutual ground when it comes to the issue of crowding out effect — when the level of public spending rises, it crowds out private sector investment.

When there is a large escalation of government spending, it is financed through borrowing out of the total savings ( investable amount) in the economy.

Given the total pool of investable amount in the economy at a given time, if the government’s share out of the pool increases, the private sector is left with less money to invest, thus reducing their share of investment in the economy.

For example, if the total saving in the economy is Rs 1000 and the government borrows Rs 200, the private sector is left with the investable amount of Rs 800. Now, if the government spending increases and their borrowing increases to Rs 500, private sector is left with only Rs 500. Hence, private investment is crowded out.

Furthermore, increase in borrowing from the internal market leads to increase in the demand for available funds, thus raising their price that is rate of interest ( in the same manner by which price of any goods increases because of increase in its demand).

The increase in the real interest rate makes investment dearer, and discourages people from investing, thus again reducing the total share of private investment in the economy.

Inflation makes investment unfavourable

The apparent impact due to highly expansionary budget is high inflation. The increase in social security spending, salaries of government officials and other routine expenses upsurges the recurrent expenditure of the government. This can lead to high inflation as people will have more money to spend in their hands.

This leads to an increase in the demand for goods and services.

Given the supply side constraints in the short run ( the supply of goods cannot be increased in a short span); it will lead to high rise in the price of goods and services, hence high inflation.

The high level of inflation does not only reduce the purchasing power of consumers but also affects producers.

The problem with public investment

An argument regarding investment is that, it does not matter where it comes from, either Large government spending and its effects on private investment.

Increasing the size of government expenditure to bring about growth is not the way forward breaking views Getting meaningful access betsandreturns. ca government or private sector ( as both bring economic growth and generate employment). However, this might not be true in the case of Nepal. If we look at the capital expenditure of the government for the past years, it has been below the target.

The spending capacity of the government is low. For example, in the fiscal 2014/ 15, the government allocated a budget of Rs 116,755,042,000 for capital/ development expenditure, but was only able to spend Rs 88,754,708,000.

Similarly, in the fiscal year 2013/ 14, the targeted capital expenditure was Rs 85,099,731,000; however the actual spending was limited to Rs 66,694,726,000 only.

Also, out of this, a large portion has been spent only at the end of the fiscal year in rush. Apart, from this, the inefficiency of the government is another factor.

There are numerous bureaucratic hurdles, red tape, et cetera that exist in government projects, making them costlier and time consuming.

This inability of the government to make capital spending and inefficiency is enough to prove that high allocation of public expenditure cannot bring positive changes in the economy. In contrast, it bars efficient private investment limiting the growth of the economy. Hence, increasing the size of government expenditure to bring about growth is not the way forward. Instead, the government should reduce its share of expenditure in the economy, and thus remove all hurdles that come in the way of private investments arising due to increase in public spending.