Does a big state crowd out private investment?

Dehenna Davison is the newly elected “red wall” Tory MP for Bishop Auckland. I am attending Bishop Food Fest next weekend, and I am hoping to say hi! Dehenna is also the co-Chair of the Conservative Free Market Forum – a grouping of hardline Thatcherites in love with a tax-cutting, government-shrinking deregulated future.

Last week in an article for Conservative Home she made this claim:

The logic behind this is simple – a big state takes up resources that otherwise could be used for investment. If there is only a fixed amount of capital to spend every pound that goes into Government borrowing is a pound that isn’t available for private businesses to invest. This is sometimes called crowding out. If you cut the size of the state there is more money available for private business to invest and grow.

I’m not a fan of big Government. In fact that’s one of the themes of this blog, how Governments mess up. But this claim is completely and totally wrong.

This same daft claim comes up so often that it is worth explaining why it is nonsense.

The UK, in common with the rest of world, operates a fractional reserve banking system. Banks can lend more out than they have as deposits, but they must hold a reserve of cash and easily convertible assets so they can deal with a sudden shock. Government bonds are a key part of this fractional reserve.

When the Government borrows it does so by selling bonds, which are bought by institutions like banks to form their fractional reserve. In turn those banks lend out several times more than the reserve to businesses and households.

If the Government borrows less, it sells fewer bonds, and there are fewer assets to form the fractional reserve. The pool of money available to the private sector shrinks not increases. Government borrowing is a key enabler of private investment, not a competitor. Shrinking the pool of available investment is what happened in the credit crunch.

Banks can choose to lend to people to buy houses, or personal loans, or lending to businesses. Banks prefer lending to buy houses because there is a tangible asset that the loan is secured against. The key competitor to businesses for finance is the housing market.

The higher house prices rise, the more money goes in mortgages and the less there is for businesses to invest and grow. Historically high house prices co-incide with historically low business investment. The house price bubble is crowding out businesses, not the Government.

There is however one area where there is some truth in the argument. Businesses are struggling to recruit to key roles as the labour force shrinks. We are competing against the Government which is hiring 18,000 new civil servants to manage the additional bureaucracy of Brexit.

Thats the real crowding out.

The public sector has spent the last 18 months dealing with the worst pandemic in a century, saving our lives and sadly sometimes losing theirs. To respond to that sacrifice by demanding massive cut backs to “bloated” “Stalinist” public services is unbelievably crass.

This is just yet another demand for more austerity, which will inflict just as much pointless damage as the last round, but in an economy which is reeling from Covid and Brexit.

In case you hadn’t spotted, this is a terrible idea, dogmatic and with no basis in economics.

Sadly for some Conservative politicians the current turmoil is an opportunity to finish what Thatcher started.

One thought on “Does a big state crowd out private investment?

  1. High house prices also, of course, hit disposable income which indirectly impacts business investment as people are less able to ‘express their market choice’.

    It’s no surprise that finance has been the big growth sector in the UK, because of the percentage of people’s income that goes into it.

    Also – about a decade ago I was working on a modernisation project for a large bank and in a getting to know you session, I think about 50% of us had started in manufacturing IT before falling into banking. It’s the area that can reliably outrun the rest, but certainly to the detriment of other business areas.

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