Crowding Out -- Isn't it Obvious?

COMPETING THEORIES

Some economists promote the fantasy that an "exogenous" increase in spending in one receiving sector can increase spending in the other sectors. Supposedly the employees in the receiving sector take their paychecks to spend in other sectors.

By the same logic, an "exogenous" reduction in spending in one receiving sector can reduce spending in the other sectors.

This is a fantasy because it neglects supply. If supply is a constraint on output -- that is, to get more output additional employees and capital have to be encouraged to produce more -- then added spending in the receiving sector pulls resources out of the other sectors.

One application of this logic is to the public sector: the debate is whether public spending would increase or decrease private spending.

TESTING THE THEORY WITH DATA FROM 2008

Another application of this logic is to the residential sector: does residential spending increase or decrease nonresidential spending? Here it is easy to see the importance of supply -- see the figure below.

When housing boomed, nonresidential construction spending fell (despite the fact that the housing boom was increasing the prices of construction labor and materials) -- almost dollar for dollar!

When housing crashed, nonresidential construction spending ROSE (despite the fact that the housing crash was reducing the prices of construction labor and materials), about 15 cents on the dollar. Note that, according to the NBER, some of the nonresidential increase occur ed during a recession.

Another fascinating property of this episode is that the shocks to spending are on the order of magnitude (100s of billions of dollars) of the kinds of fiscal stimuli being recommended by some economists.

When interpreting what is above, we need to recognize that a large sector is omitted -- the non-construction sector. For this reason, the calculations above underestimate of the aggegate supply effect of housing spending on nonresidential spending (Take, for example, accountants. A housing boom pulls accountants into work for construction businesses, which leaves fewer accountants to work for non-construction businesses.). But they also underestimate the aggregate demand effect, because the housing construction workers are taking their paychecks and spending some of it on non-construction items. In any case, the supply effect is easy to see -- the housing construction boom did not take place with resources that would have otherwise been unemployed and the housing bust did not release resources entirely into unemployment.

Interestingly, this single graph both helps the case for crowding out and helps the case FOR Obama's fiscal stimulus. More on that paradox to come...