Crowding out is an economic concept where increased public sector spending and borrowing lead to a decrease in private sector capital investment.
Understanding crowding out
When a national government runs a budget deficit, it issues bonds to raise funds. This action increases the demand for loanable funds in the financial markets. Because the supply of domestic and international savings is finite at any given moment, this new demand pushes up interest rates.
Higher interest rates make borrowing expensive for private businesses. Companies planning to build factories or buy machinery often cancel or delay these projects because the cost of debt is too high to justify the expenditure. The government absorbs the available capital from the financial system. This leaves less money for private enterprise to use for expansion.
The severity of the effect depends on the broader economic environment. During a recession, private investment is usually low. Government borrowing in this scenario does not displace much private capital. When an economy operates near full capacity, government borrowing directly competes with the private sector for a limited pool of funds. Central banks can alter this dynamic by expanding the money supply to keep interest rates low, but this monetary expansion introduces long-term inflation risks.
Example
Suppose you and your fellow Elephants manage an international agriculture firm. You plan to borrow funds from a commercial bank to purchase a new fleet of heavy tractors. At the exact same time, the national government decides to build a large hydroelectric dam. The government issues high-yield bonds to finance the construction. Investors and banks prefer the security of the government bonds and purchase them in large volumes. The commercial bank raises its corporate loan interest rates to manage the shrinking pool of available capital. You review the new interest rates and calculate that the tractor expansion is no longer profitable. You cancel the equipment purchase. The government successfully financed the dam, but its borrowing crowded out your private investment.