The effect of government spending to spur the economy is undermined when government finances the stimulus by borrowing money, according to a new mathematical model developed by a Rensselaer Polytechnic Institute professor.

Economist and Clinical Professor of Economics John Heim said the new model pinpoints the negative “crowd out” effect of government borrowing on private investment, an effect overlooked by John Maynard Keynes, upon whose 20th century work current policies of deficit spending in times of recession are based. 

Heim’s work calculates that the effect of each dollar of government stimulus - whether tax cuts or increased government spending - financed by borrowing is eroded by a factor of  at least 100% due to crowd out effects. In other words, Heim said, government “stimulus” financed by borrowing has a net negative effect on the economy.

The findings, which are detailed in the Journal of the Academy of Business and Economics, sound a cautionary note to leaders grappling with economic downturns.

“What this means for public policy is that you should expect that a stimulus will not have the effect that politicians expect it to have,” Heim said. “In a recession, everyone falls back on a Keynesian stimulus. Keynes never seriously addressed the ‘crowd out’ factor.”

Heim specializes in research that converts statistics into mathematical models depicting the economy – a field known as econometrics.

Crowd out, Heim said, turned out to be an excellent subject for research.

Crowd out begins with the point that the pool of money available to be borrowed – to fuel private investment and consumption – is limited.

“Businesses and consumers buy much of what they buy with borrowed money - consumers using credit card borrowing, car loans; businesses using bank loans for new factory equipment, etc.,” Heim said. “If government borrows part of the money available, it reduces what’s left for businesses and consumers to borrow.”

If the government borrows massive amounts of money to finance and economic stimulus, the government absorbs much of the pool. In doing so, the government limits – or “crowds out” – private investment and consumption fueled by borrowing. By hindering private investment and consumption, the effect of the money spent in the stimulus is dampened.

“Most of the people who have addressed this issue in the years since 1930 were people in the business press, not the scientific press,” Heim said. “There’s been a lot of deductive work done, but there ought to be more scientific work done than there really is.”

Heim’s work builds on current models for Gross Domestic Product (GDP) – a measure of the nation’s production in a given year. Although the basic formula is very simple – GDP = Consumption + Investment + Government spending + Net exports– economists have deepened the formula over decades of research to account for the complex composition of each of these variables and the relationships between them.

For example, economists have calculated that consumption – which drives GDP – is in turn determined by disposable income, wealth, interest rates and the exchange rate, and that a change in any of those variables changes consumption.

Heim[‘s] used statistics from the Economic Report of the President,  an annual report generated by the President’s Council of Economic Advisors, to test whether the current model works for the best possible data on the United States economy.

When he first plugged numbers from the report into current mathematical equations for GDP in the summer of 2003, he came up with a result he knew to be impossible.

 “I came up with a positive relationship between taxes and GDP testing standard Keynesian models– when taxes went up, GDP went up. I thought I must be doing something wrong and I spent a whole summer trying to calculate properly,” Heim said. “It took three years to figure out that it was because of crowd out.”

Heim used multiple regression analysis – a technique used by other econometricians, mathematicians and engineers – to test the relationships between the components of GDP.

Only when he added a crowd out variable to standard Keynesian models, and retested them did the statistical results explain the positive coefficient on taxes.

“The test results obtained represent the average way over a 40 years period that the change in deficit affected the consumption and investment components of the GDP,” Heim said.

The finding fits patterns of GDP in times of heavy government borrowing, Heim said.  As GDP increases, investment should increase. But after 1982, Heim said, investment fell far below predicted figures as the U.S. government started running large deficits. In 1998, it rose considerably above predicted figures as the U.S. government started running surpluses.

“Why was that? There was a huge tax cut in 1982 in the U.S., roughly speaking everyone in the U.S. saw their tax bills decline 25%. Unfortunately spending wasn’t cut so the budget ballooned enormously in the ‘80s and to finance the budget what they did was borrow money,” Heim said.  “That cut down markedly on the amount of money businesses could borrow for investment, and investment dropped, just as crowd out theory would lead us to believe.”

In 1998, for the first time since 1967, the United States government experienced a budget surplus, allowing it to cease borrowing and retire outstanding debt.

“From ‘98 to 2000, sure enough, businesses could borrow more money than had been available prior to 98, invested more than one would expect from the historic trend.

The full text of Heim’s paper – “Do Government Deficits Crowd out Consumer Spending and Investment” – is available from the Working Paper section of the Rensselaer Department of Economics. Heim’s paper is marked working paper #1005. A link to the site is as follows:

Contact: Mary L. Martialay
Phone: (518) 276-2146
E-mail: martim12@rpi.edu