Production of output in an economy requires labor and real capital inputs. Capital includes real items such as machines and buildings as well as propr

Explainer: Capital Crowd Out Effects of Government Debt

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2021-07-01 10:00:06

Production of output in an economy requires labor and real capital inputs. Capital includes real items such as machines and buildings as well as proprietary intangibles such as patents and software. To create more capital, certain goods and services are allocated from total domestic output to make new capital. Capital wears out and depreciates, so capital formation to restore productive capacity of the economy is required just to maintain a given level of economic output. Growth of the economy requires even more capital in order to keep up with growth of the labor force. Therefore, some portion of economic production must always be devoted to capital production.

Broadly, when government action reduces the amount of capital investment in the economy, the long-run growth of the economy declines. This effect can be partially mitigated if new deficit-financing spending takes the form of human capital investment, public capital, and public goods such as research, which are also productive. Government actions which cause redirection of investment toward consumption may improve social welfare (by various metrics), but the economy might still be smaller than without that increased debt.

With low government borrowing rates, it might seem that government borrowing would have little cost. However, when projecting expected (likely) future outcomes due to large deficits, the economy’s return to private capital investment must also be accounted, which is larger than the government borrowing rate.