In traditional economic theory, the crowding-out effect, to whatever extent it occurs, reduces the multiplier effect of deficit-funded government spending aimed at stimulating the economy. The crowding-out effect and the multiplier effect can be viewed as two contrary, or competing, possible impacts of government economic intervention funded by deficit spending. Some economists even theorize the crowding-out effect completely negates the multiplier effect, so in practical terms, there is no multiplier effect induced by government spending.
The multiplier effect refers to the theory that the effect of increased government spending to stimulate the economy is multiplied by producing increases in private spending that additionally stimulate the economy. In essence, the theory is government spending supplies households with additional income, which leads to increased consumer spending, in turn leading to increased business revenues, production, capital expenditures and employment, further stimulating the economy. Theoretically, the multiplier effect is sufficient to eventually produce an increase in total gross domestic product, or GDP, that is greater than the amount of increased government spending.
The competing force, the crowding-out effect, basically refers to government spending “crowding out” private investment by using up part of the total available financial resources, and also to the depressive effect deficit funding of government expenditures can have on stimulating the economy. The crowding-out theory rests on the assumption that government spending must ultimately be funded by the private sector, either through increased taxation or financing. Therefore, the government spending effectively uses up private resources, creating a cost that has to be weighed against possible benefits derived from the government spending. It can be difficult to estimate the cost, since it is primarily a cost of lost opportunity that involves estimating the amount of economic benefit that could have been derived from the private sector using the resources diverted to the government.
In short, the crowding-out effect is the dampening effect on private sector activity that results from the public sector activity. Since the crowding-out effect reduces the net impact of government spending, it correspondingly reduces the extent to which government stimulus spending efforts are multiplied. Part of the crowing-out equation rests on the idea there is a finite supply of money available for financing, and that whatever borrowing the government does reduces private sector borrowing, and therefore may negatively impact business investments in growth. But the existence of fiat currencies and a global capital market complicate that idea by bringing into question the very notion of a finite money supply.
There is an intense debate between economists, especially in the wake of massive government spending initiated after the 2008 financial crisis, as to the validity of the multiplier effect and the crowding-out effect. Classical economists argue the crowding-out effect is the more significant factor, while Keynesian economists argue the multiplier effect more than outweighs any potential negative impacts resulting from the crowding out of private sector activity. However, both camps are largely agreed on one point: government economic stimulus activities are only effective on a short-term basis; ultimately economies cannot be sustained by a government that is perpetually operating deeply in debt.