Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How Public Debt Crowds Out Private Investment
Transcript
- Lucas: So, here is the thing about public debt that usually gets lost in the noise of political shouting matches. It isn't just about whether the government can pay its bills tomorrow. It is about what happens to the price of money for the rest of us when they borrow too much. Luna: Right, because every dollar the Treasury issues is a dollar that has to be absorbed by investors, which changes the baseline cost for everyone else looking for capital. Lucas: Exactly. We call this crowding out. And while economists have debated the strength of this effect for decades, the data from the last quarter suggests it is becoming a very real constraint on private sector expansion. Let's look at the mechanics. When the government runs large deficits, it increases the supply of bonds. To attract buyers, it has to offer higher yields. Those higher yields don't just sit there; they ripple through the entire credit market. Luna: And that makes sense because banks and institutional investors have limited capital. If they lock it up in safer government paper, they have less available to lend to riskier private ventures. Lucas: Precisely. But it goes deeper than just bank reserves. Think about a mid-sized manufacturing company planning a new facility. They were going to finance it with twenty-year bonds at six percent. Now, because the government is flooding the market with debt, those twenty-year Treasury yields have ticked up to seven percent. The company doesn't just accept that; they raise their hurdle rate. Suddenly, the project looks too risky at eight percent, so they cancel it or delay it. That is direct crowding out of productive investment. Luna: It feels like we are seeing this play out in the commercial real estate space right now, where refinancing costs are spiking due to broader yield curve pressures. Lucas: That is a perfect example. And it isn't just large corporations. Small businesses rely heavily on floating-rate debt tied to prime or LIBOR alternatives, which move in sympathy with Treasury benchmarks. When the Federal Reserve keeps rates elevated to manage inflation, but the Treasury keeps issuing debt at even higher yields to cover deficits, you get a double squeeze on credit availability. Luna: Yeah, and I think people forget that crowding out isn't always immediate. It can be gradual, shifting capital away from innovation toward safer, lower-yield government assets over time. Lucas: That is a crucial distinction. There is the immediate financial crowding out, which is just about interest rates. Then there is the longer-term resource crowding out. If the government borrows massively, it pulls labor and materials into public projects that might not be the most efficient use of those resources compared to what the private sector would have built. It distorts the entire economy's allocation of talent and steel. Luna: So it is not just the cost of money, but the competition for the actual physical inputs needed to build things? Lucas: Exactly. And here is where it gets tricky for policymakers. They need to spend on infrastructure and social safety nets, but if they do it all through debt without raising taxes, they risk stifling the very private sector growth that generates the tax revenue they need later. It is a catch twenty-two. In September 2026, we are seeing states struggle with this exact balance. Some are freezing hiring to avoid driving up wage costs, which indirectly affects private sector wages too. Luna: I wonder if this is why we are seeing such a divergence between tech stocks, which can wait for better financing conditions, and industrial stocks, which are hurting right now. Lucas: Spot on. Tech companies often have cash hoards or access to equity markets, which aren't directly affected by bond yields in the same way. Manufacturers? They live and die by their debt service ratios. A half percent increase in borrowing costs can wipe out the projected margin on a new factory line. So when you see industrial production stagnating, look at the bond market first. Luna: It makes me question the narrative that government spending always stimulates growth. Sometimes it just changes the composition of growth toward public goods and away from private expansion. Lucas: That is the core tension. Stimulus works when you have idle resources. But when the economy is near full capacity, government borrowing doesn't create new activity; it just redirects existing activity. And since the government is often less efficient than the private market at allocating those resources, you end up with a net loss in productivity. It is a subtle drag, but compounding year over year, it matters. Luna: So, how do investors protect themselves from this? Do they just assume higher rates will persist? Lucas: They start pricing in the risk premium differently. You see it in credit spreads widening. Investors demand more compensation for holding corporate debt relative to Treasuries because they fear that government issuance will keep pushing up the risk-free rate. It forces companies to either issue shorter-term debt, which rolls over sooner, or lock in long-term rates now at a premium. Both strategies have costs. Luna: Shorter-term debt means more refinancing risk. If the market tightens further, they could get squeezed at maturity. Lucas: Right. And that leads to a scenario where companies hoard cash instead of investing. It creates a deflationary pressure on capital expenditure. We saw a lot of cash accumulation during the pandemic, but now that the zero-rate era is gone, that cash is being used to pay down debt, not build new plants. It is a defensive posture driven by the cost of capital. Luna: It feels like we are entering a phase where financial discipline becomes the primary driver of corporate strategy, rather than aggressive growth. Lucas: I think that is accurate. Growth is still possible, but it has to be highly efficient. Margins get compressed. Waste is eliminated. And the barrier to entry for new competitors rises because they can't afford the initial borrowing costs. That entrenches incumbents who already have strong balance sheets. Luna: So crowding out might actually accelerate consolidation in many industries. Lucas: Absolutely. Mergers and acquisitions might slow down in volume because financing is expensive, but the ones that do happen tend to be larger, strategic consolidations that require massive capital. Smaller players get squeezed out. It reshapes the competitive landscape in ways that aren't immediately visible on quarterly earnings calls. Luna: That is a sobering thought. It means the invisible hand of the market is getting a heavier push from the visible hand of the Treasury. Lucas: A heavy push indeed. And as we move through the rest of 2026, watch for any signs of fiscal dominance, where monetary policy starts to accommodate government debt needs. That would be the ultimate form of crowding out, effectively forcing private savers to fund public spending at below-market rates. Luna: We haven't seen that yet, but the risk is certainly on the table if deficits continue to widen without political resolution. Lucas: For now, the market is keeping rates high enough to discourage excessive borrowing. But it is a delicate equilibrium. One shock to bond demand could send yields spiking, and then the crowding out effect becomes an acute crisis rather than a slow bleed. Luna: It really highlights why fiscal responsibility isn't just a political talking point. It is a fundamental component of economic stability. Lucas: Well said. And that brings us to how we keep this show running. We deliberately don't run ads on these episodes. We believe that discussing complex topics like crowding out requires nuance, not interruption. If walking through the economy with us has made something click, and you want to support that choice, the link is buy me a coffee dot com slash fexingo. Luna: Your support helps us dig deeper into these mechanisms without needing to chase clicks or sponsorships. Lucas: Thanks for helping us stay independent. Now, let's go back to the practical side. How does a small business owner actually navigate this environment today? Luna: Good question. I think the first step is to audit your debt structure. Are you locked into variable rates when you should be fixed? Or vice versa? Lucas: Right. And diversify funding sources. Don't rely solely on one bank. Build relationships with multiple lenders before you need the money. When credit tightens, having options is everything. Luna: And consider equity financing if possible, though that dilutes ownership. It is a trade-off between cost of capital and control. Lucas: Exactly. Every decision is a balance sheet management exercise now. The era of cheap money is over, and we have to adapt to a world where capital is priced according to true scarcity. Luna: It is a harder world, but maybe a more honest one. Where value creation has to truly justify the cost of the resources used. Lucas: Perhaps. But it also means that efficient operators will thrive while inefficient ones fade. The market is filtering itself in real time. Luna: So the next time you hear about a new infrastructure bill or a spike in Treasury yields, remember that it isn't just background noise. It is changing the rules of the game for every business around you. Lucas: That is the takeaway. Keep an eye on the bond market, and you will see the future of private investment before it hits the headlines.