Study Notes:

Mainstream economists assert that when national governments run deficits and issue debt, they crowd out more productive private spending.

The assertion is a central part of the mainstream attack on government fiscal intervention. At the heart of this conception is the Classical Loanable Funds theory, which creates a fictional rendition of the way financial markets work. I won't go into the full history of this theory, although if you want to get a serious understanding of the debates in macroeconomics then you have to become familiar with this literature.

For our purposes, the crowding out hypothesis is based on the claim that at any point in time, there is a limited supply of private sector saving for which government and private sector borrowing compete. If government tries to borrow more, by issuing and selling more bonds, then the competition for finance would push up interest rates as the demand for saving rises relative to a scarce supply. The upshot is that some private firms would then find that the higher borrowing rates render their investment projects unprofitable and so private investment expenditure falls.

They also claim that private investment spending is always more productive and desirable than wasteful government spending, because private firms have to face the market test to survive while there are no shareholders to 'keep government honest'.

A careful understanding of what drives saving and how banks actually operate shows that the basic crowding out hypothesis is inapplicable in modern monetary systems.

First, government deficits stimulate sales, which leads to higher GDP (income). As a result, the pool of savings expands because saving is a function of GDP (income). The other way of understanding this is that government deficits generate non-government surpluses that accumulate to increased wealth holdings in the non-government sector - as we have learned in Week 1.

Since there are more savings and greater financial wealth, government borrowing does not reduce the pool of funds available to private sector borrowers. Quite the contrary.

Second, if we examine the way modern banks operate, it further becomes obvious that the crowding out conjecture does not apply to the real world.

Students in mainstream banking courses are told that commercial bank lending is reserve constrained. That is, banks are considered to solicit deposits from lenders, which then allows them to build up reserves that they can then loan out.

But in the real world, bank loans are not reserve-constrained. Banks do not just sit around waiting to dollop out their current deposits to lenders in some sort of rationing plan.

Banks solicit credit-worthy borrowers to extend loans to. Importantly this means that loans create deposits, not the other way around.

To extend the discussion, we need then to understand the role of bank reserves.

The commercial banks all have to maintain reserve accounts with the relevant central bank. The funds in those accounts are used exclusively as a means to settle all the daily transactions between banks.

Loans create deposits which can then be drawn upon by the borrower. No reserves are needed at that stage. The loan desks of commercial banks have no interaction with the reserve operations of the monetary system as part of their daily tasks. They just take applications from credit worthy customers who seek loans and assess them accordingly and then approve or reject the loans.

The reserve accounts are a centralised way to resolve the various cross-bank claims each day. Refer back to the previous discussion on fiscal and monetary policy.

If a bank is short of reserves on any particular day, they can seek loans from other banks with excess reserves. If they cannot source sufficient reserves to cover all the transactions drawn against them, then they can always borrow from the central bank. The central bank stands ready to ensure there are always sufficient reserves to ensure financial stability is maintained.

The reality is that banks only loan excess reserves among themselves as part of the payments system (cheque clearing) and that lending is not constrained by deposits (and hence, reserves). Banks do not loan out reserves to customers. They do not need to. They can create loans with a keyboard entry.

In short, fiscal deficits do not reduce the capacity of private borrowers to access funds in the financial markets. Moreover, given that fiscal deficits provide stimulus to the private economy, they also provide conditions propitious for profit-making and greater investment opportunities. Rather than crowding out private spending, fiscal deficits actually crowd-in private opportunities.

There is another narrative that an advanced course would relate where fiscal deficits actually create excess reserves in the banking system which places downward pressure on interest rates. But that story is beyond this introductory course.