Since Alan Greenspan relinquished his role as chairman of the Federal Reserve, he has been vocal that increased government spending, specifically entitlements, are crowding out investments, which is hindering productivity growth. In this article, we explore the mechanisms by which government spending can crowd out investments and explore the implications of Greenspan’s warnings about entitlement growth in the United States.
National Income Accounts
The classic definition of GDP is below. For more detail on GDP, refer to this article.
GDP (Y) = Consumption (C) + Investment (I) + Government Purchases (G) + Net Exports (NX)
If we simplify our view of the world and assume a closed economy that does not trade with other countries, then, the output of the economy (GDP) will be:
Y = C + I + G
Output (Y) is a function of two factors: 1) labor and 2) capital. In a simple model, an economy has a fixed amount of labor at any given moment in time. An economy also has a fixed amount of capital at any given moment in time. The utilization of the labor available and capital available dictates what the output of the economy can be. We can think of Y as representing supply and C + I + G as representing the demands of that output.
Consumption is spending on goods and services by consumers, which include both durable and non-durable goods. Consumption is funded out of household’s disposable income, which is measured as output less all taxes paid to the government. Out of a household’s disposable income, households will put a certain amount into Savings (S) and the rest will go towards Consumption (C).
Investment consists of new home purchases by households and fixed assets purchased by businesses. These fixed asset purchases can include equipment, technology, IT infrastructure, production facilities, etc. Ultimately, the level of investment demanded in the economy is directly affected by the interest rate. As real interest rates increase, investments become less profitable, so the total investment demanded decreases. However, as real interest rates decrease, investments become more profitable, so the demand for investment increases. For example, if a business can borrow at 2% and earn a return of 8% on an equipment purchase, the business will pursue this investment. However, if the cost of borrowing is 9% and the return on this equipment is 8%, the business will not pursue this investment
Government purchases include all federal, state, and local spending on services provided for the country and spending on government employee wages. Government purchases do not include payments for social welfare programs, such as Social Security.
Equilibrium Interest Rate
The equilibrium interest rate is the interest rate at which demand for goods and services is equivalent to the supply for demands and services. Remember, in the above equation, Y represents the supply of goods and services, whereas the demand for Y is denoted by C + I + G.
The interest rate factors into the Y = C + I + G equation since it is a direct driver of Investments. With a higher interest rate, the number of profitable investment projects go down, and with a lower interest rate, the number of profitable investment projects go up.
In a simplistic model, all the variables within Y = C + I + G are fixed except for the interest rate. Let’s see why:
Y: Output is fixed as it is determined by the availability of capital and labor. With a fixed amount of capital and labor available in the economy, output is fixed at a certain level
C: Consumption is a function of disposable income, which we define as Y – T, where T represents taxes paid to the government. Therefore, a portion of Y – T will go towards consumption and a portion will go toward savings. Since Y is fixed (as noted above) and T is fixed based on government policy, consumption must also be fixed in our model
G: Government purchases are also fixed based on policy mandates
Therefore, if Y, C, and G are fixed in this model, then, Investments will adjust to balance the equation based on the interest rate that brings demand for goods/services into equilibrium with supply. Let’s re-arrange the above equation:
Y = C + I + G
Y = C(Y – T) + I(r) + G
*Note: Consumption is a function of (Y – T). In other words, the level of consumption is based on the level of disposable income, which is (Y – T). Investments is a function of interest rates, so the lower the interest rates, the higher the level of investment
I(r) = Y – C(Y – T) – G
*Note: Y – C(Y – T) – G is equal to national savings (S). After deducting consumption and government purchases from output, we are left with national savings, which is the combination of private savings and public savings. Private savings is equal to Y – T – C, which is disposable income less consumption. Public savings is equal to G – T, which is government purchases less taxes collected
I(r) = S
*Note: Substituting savings (S) for Y – C – G now shows us that Investment must be equal to Savings
In this simplistic model, savings is a fixed amount because Y, C, G, and T are all fixed amounts. We can now see that the level of national savings in the economy is determined by the production factors (availability of capital and labor) which drive Y and C and is also determined by fiscal policy, which drive G and T.
With savings being at a fixed level, we can see that the level of savings determines the equilibrium interest rate. When the savings level increases, more loanable funds are available to those who demand it for investment projects. Therefore, when savings level increase, the interest rate decreases. And when the savings level decreases, the interest rate increases.
Another way to look at the equilibrium interest rate is that it is the level at which the supply of funds matches the demand for funds. In this case, the supply of funds is equal to savings and the demand for funds is equal to investment.
*Note: In this simple model, we are assuming that the savings level is not influenced by interest rates. We are also assuming that it is a closed economy that does not trade with other countries and that the labor force is at full employment.
Effect of Government Purchases on Savings and Investment
We’ve now established that savings is equal to investment, and savings is determined by Output less Consumption less Government Purchases:
S = Y – C – G
Assuming output stays the same and consumption stays the same, an increase in government purchases must decrease savings (remember, savings is the total of private and public savings). Since savings is equal to investment, a decrease in savings also equates to a decrease in investment. Another way to look at this is that an economy’s output (which we’ve established as being fixed) is demanded by three sources: consumption, investment, and government purchases. Since consumption is a function of disposable income and will not change, increased demand from government purchases must be offset by decreased demand for investment.
On a less abstract level, lets imagine that the federal government wants to fund a $1 trillion infrastructure program. The government must fund this $1 trillion expenditure by either increasing taxes, which reduces private savings, or by borrowing $1 trillion dollars, which also reduces savings as the supply of loanable funds has gone down. With decreased savings due to the increased government expenditure, the equilibrium interest rate must go up due to having less funds that can be loaned out. With a higher interest rate, less investment projects are profitable.
Therefore, an increase in government purchases crowd out private investment vis a vis a higher equilibrium interest rate, which makes more investment projects unprofitable.
Effect of Tax Policy on Savings and Investment
A decrease in taxes results in increased consumption. Remember, consumption is a function of output less taxes:
C = C(Y – T)
If T goes down, then, C must go up. Consumption will not go up by the full amount of the tax reduction. Instead, part of the tax reduction will go into increased consumption and part of the tax reduction will go towards increasing private savings.
Let’s return to our savings equation:
S = Y – C – G
If C has now gone up by and Y and G are the same, then, S must now be lower. With lower savings, the equilibrium interest rate must rise, which causes a decrease in investment. It may seem counterintuitive that savings will go down if there is a tax cut, but remember, that savings is the combination of private savings and public savings. If the government passes a $500 Billion tax cut, then, public savings go down by $500Bn. That $500Bn now shifts into consumer hands. If consumers saved 100% of this, then, total savings in the economy would remain the same, and interest rates would remain the same. Instead, if consumers spend 70% of the $500Bn, then, consumption will go up by $350 Billion and total savings in the economy will also go down by $350Bn.
Therefore, a decrease in taxes results in higher consumption which crowds out private investment vis a vis lower savings and a higher equilibrium interest rate, which makes more investment projects unprofitable.
Alan Greenspan on Entitlements Crowding Out Savings
Alan Greenspan has been warning for many years that growing deficits driven by the US government’s large unfunded entitlement programs (Social Security, Medicare) is reducing national savings, which in turn is reducing investment. Greenspan believes that the reduction in investment is leading to low productivity growth, which has only been 0.50% in the years following the financial crisis.
With productivity growth of less than 1% and an aging labor force that caps the growth rate in available labor, Greenspan believes GDP growth may stall out for many years to come.
Listen to Greenspan’s analysis in this December 2016 Bloomberg interview:
