Intro: Fiscal deficits crowd out private investment by reducing savings available in the economy for the private sector to invest. Under free market conditions, the reduction in real savings will tend to put upside pressure on interest rates, but this is not necessarily the case if the central bank chooses to offset these upward pressures vias easing measures. Nonetheless, the key point to note is that crowding out occurs in the market for real goods and services regardless of whether upside interest rate pressures manifest.
Persistently large fiscal deficits tend to result in higher interest rates and inflation than would otherwise have been the case, but so many factors are at play that we cannot simply assume that large deficits will automatically lead to spiraling inflation and borrowing costs. In fact, large fiscal deficits often coincide with easy monetary policy so that upiside interest rate pressure may not manifest. The key point to note however is that if a government runs large fiscal deficits due to excessively high levels of spending, this will tend to undermine the availability of savings in the economy. Even if other factors keep interest rates low, the crowding out still occurs in the market for real goods and services.
The textbook explanation of crowding out is that fiscal deficits aimed at boosting investment can be counterproductive in the event that the additional government bond issuance causes bond yields and interest rates to rise, which in turn undermine private investment. Ultimately, higher interest rates mean that government investment is offset by lower private investment.
The assumption that this makes, however, is that the upside pressures on interest rates are allowed to play out. If, as is common, central banks attempt to keep interest rates lower than they would otherwise have been, this does not mean that crowding out doesn’t occur. Rather, it means that interest rates are just not being allowed to adjust to as they should do in response to a likely reduced availability of savings, creating the potential for economic distortions to build up.
Japan provides a great example of where crowding out has occurred dramatically in spite of interest rates remaining close to zero for years. As the government has increased spending far in excess of taxation, the Bank of Japan has bought government bonds to prevent yields from rising. Nonetheless, private investment has continued to shrink as a share of the economy as government spending has increased, and economic growth overall has stagnated. The reason is that the government has increasingly diverted resources towards social spending at the expense of private investment.