Watch Out for Crowding Out

A look at aggregate saving and investment

The nation’s economic statistics include what are called accounting identities. They have to add up. The identity that I will work with here is sometimes called the flow-of-funds identity:

Investment = Domestic Saving + Foreign Saving - Government Deficit

This is always true, by the definition of the aggregates involved. Any macroeconomic model or analysis that breaks this identity is nonsense. From now on in this essay, I am are going to leave out Foreign Saving, which is the saving provided to our economy by foreign households and governments as we run a trade deficit.

The tricky part of macroeconomics is deciding within this identity what drives what. If there were no government deficit, we would have

Investment = Domestic Saving

In the Classical world, the driver at work is the interest rate. The interest rate has to be just high enough to call forth saving to finance investment.

When we bring the government deficit back into the Classical world, we get “crowding out” of Investment. The government borrowing drives up the interest rate, and there is less Investment.

In the Keynesian Recession world, the interest rate has failed to equate Investment with Domestic Saving. There is a shortfall of Investment, which drives down income. With less income, there will be a reduction in Domestic Saving, until Domestic Saving matches the low level of Investment. According to the Keynesian story, a Government Deficit helps to absorb Domestic Saving and mitigate the recession.

In a Minsky/MMT world (Minsky is the late Hyman Minsky and MMT is Modern Monetary Theory), a Government Deficit is matched by corporate profits, which are part of Domestic Saving (the other part is household saving). Even if the economy is not in a recession, the government can run a big deficit without adversely affecting investment, because corporate profits absorb the deficit.

In the immediate aftermath of the Financial Crisis of 2008, we had a collapse in a major component of investment, namely housing construction. We seemed to enter a Keynesian Recession world, and Congress passed big pending bills in 2008 and 2009 as a Keynesian remedy.

From about 2010 through 2019, as Domestic Saving recovered from the recession, interest rates remained low, and this encouraged an increase in (non-housing) investment. Many macroeconomic analysts say that the Fed kept interest rates low. But one can tell the story without the Fed. The increase in Domestic Saving and a reduced Government Deficit made the low rates possible.

In 2020, the pandemic hit, and under both President Trump and President Biden, the government went crazy with big deficits. They acted as if we were in Keynesian Recession world, even though the decline in economic activity was due to pandemic-related closures, not to an excess of saving relative to desired investment.

In this context, the deficits caused a bulge in Domestic Saving. Some of this went into long-term investments, including apartment buildings and venture-funded start-ups.

Then, even with the pandemic over, President Biden kept the deficit machine going by spending on “green energy” and other progressive priorities without raising taxes to pay for this surge. The Democrats acted as if we were in the Minsky/MMT world, and these deficits would not matter.

As it turns out, in 2023 we are in something like Classical world. The big deficits now are crowding out private investment. Moses Sternstein talks about venture capitalists and others suddenly feeling squeezed.

Q3 had more startup closures than all of 2019 combined.

Similarly, Aswath Damodaran writes,

if you are a venture capitalist or a company founder, battered by down rounds and withheld capital, the end is not in sight yet.

As far as risky investment in the private sector is concerned, think of higher interest rates as a game of musical chairs in which the music suddenly stopped and several chairs have been taken away. In the scramble for capital, somebody is going to lose.

substacks referenced above:

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Market Bipolarity: Exuberance versus Exhaustion

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Random Walk at Night: Investors are raising money for a lending bonanza