Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How Government Debt Crowds Out Private Investment
Transcript
- Lucas: The word that keeps coming up in every fiscal briefing I read this week is 'crowding out.' It sounds like an economic law of physics, like gravity, but it’s actually a messy, political choice about who gets to borrow money first. Luna: Right, because the government always gets to borrow first at the lowest risk premium, which leaves the rest of us fighting for whatever liquidity is left. Lucas: Exactly. And if you look at the ten-year Treasury yield right now in October twenty twenty six, it’s hovering in a range that makes private corporate borrowing significantly more expensive than it was five years ago. That’s not just inflation; that’s the cost of carrying national debt being passed directly to your balance sheet. Luna: So when a mid-sized manufacturing company wants to build a new plant, they’re not just competing with other companies, they’re competing with the federal treasury. Lucas: Precisely. And here is the concrete detail most people miss: it’s not just about the interest rate going up. It’s about the duration mismatch. The government locks in cheap money for thirty years, while private firms need flexible, shorter-term capital for innovation. When the safe asset becomes too abundant, it distorts the entire pricing model of risk. Luna: That’s a great point about flexibility. Innovation needs agility, and high fixed debt costs kill agility fast. Lucas: Let’s look at a specific case from the late nineteen eighties. When the United States ran massive deficits under Reagan, we saw a sharp decline in private capital formation relative to GDP. Businesses didn’t stop investing entirely, but they shifted toward financial engineering—buybacks and mergers—because building physical factories became too costly compared to buying back shares. Luna: So the economy got richer on paper, but the productive capacity stagnated because the credit went to shareholders instead of factories. Lucas: Spot on. And today, we are seeing a similar shift. With the federal debt to gdp ratio near historic highs, the pool of available savings is largely absorbed by government issuance. This leaves private enterprises with higher marginal costs of capital. It’s a quiet tax on entrepreneurship. Luna: It feels like we are trading long-term productivity for short-term fiscal relief. Lucas: Before we dive deeper into the mechanics of how this impacts small business lending, I want to take a quick moment to talk about the show itself. If walking through the economy with us has made something click for you, or if you appreciate getting these complex fiscal concepts without the noise, consider supporting the network directly. You can find us at buy me a coffee dot com slash fexingo — that's F. E. X. I. N. G. O. Your support helps keep these episodes ad-free and allows us to dig into the details like we are doing today. Luna: Yeah, it really helps us get the research done so you don’t have to wade through the press releases yourself. Lucas: Back to the mechanism. There is a common misconception that crowding out only happens when the economy is at full employment. That is true in classical theory, but in a modern fractional reserve system, it happens differently. It happens through the price signal. Luna: So even if there is idle labor, the cost of borrowing rises because investors demand higher yields to hold corporate debt over government debt. Lucas: Correct. And this is where the VIX and the credit spreads come into play. When the government issues trillions in debt, it creates a floor for interest rates. Corporations that rely on floating-rate debt see their margins compress immediately. We saw this with several regional banks in early twenty twenty four when their loan books couldn’t compete with the yield on safe assets. Luna: So the banks aren’t just losing money on bad loans; they are losing the spread because the risk-free rate is eating their margin. Lucas: Exactly. And this trickles down to the small business owner. If a local restaurant chain wants to expand, they look at their cost of capital. If that cost is tied to a benchmark that has been pushed up by sovereign debt issuance, they delay expansion. That is the crowding out effect in action. Luna: It’s subtle, but it stops jobs from being created before they ever hit the ground. Lucas: Now, let’s challenge the framing for a second. Some economists argue that crowding out is overstated because central banks can manage liquidity. But does quantitative easing actually solve the problem, or does it just delay the pain? Luna: I think it delays it by creating asset bubbles elsewhere, like in real estate, while the real economy—the stuff you and I deal with—still faces higher borrowing costs. Lucas: That is a crucial distinction. When the Federal Reserve buys Treasury bonds, it suppresses yields temporarily, but it also inflates asset prices. So the wealthy see their portfolios grow, but the borrower still faces higher rates for new loans because the risk premium hasn’t disappeared; it’s just been hidden. Luna: So the distortion moves from the credit market to the equity and property markets. Lucas: Right. And this brings us to the state level. Look at California or New York. Their pension obligations are so large that they have effectively crowded out capital improvement budgets. Schools are crumbling not because of lack of revenue, but because the debt service on past promises is consuming current cash flow. Luna: That is terrifying. It means we are paying for decisions made thirty years ago at the expense of children in classrooms today. Lucas: And it’s not just pensions. Look at infrastructure. When the federal government borrows heavily, municipal bond yields often rise in sympathy. This makes it harder for local governments to fund transit or water systems. The crowding out isn’t just theoretical; it’s visible in the potholes and the delayed train lines. Luna: So the invisible hand of the market is actually being held by a very heavy government glove. Lucas: A fitting metaphor. Now, is there any scenario where crowding out doesn’t happen? Yes, during deep recessions. When private demand collapses, the government can step in without displacing private investment because there is no private investment to displace. But we are not in a deep recession right now. Luna: We are in a period of sluggish growth with sticky inflation, which is exactly the worst environment for high debt costs. Lucas: Exactly. In a stagnation phase, high debt acts as an anchor. It prevents the natural reallocation of capital to more productive uses. Zombie companies stay alive because they can refinance their debt at manageable rates, while healthy startups can’t get funding. Luna: So the economy becomes less dynamic, less innovative, and more fragile. Lucas: More fragile. And when a shock hits, like a supply chain disruption or a geopolitical event, those zombie companies drag down the whole system. They consume resources without generating value. Luna: It’s basically economic sclerosis. The blood flow stops reaching the extremities. Lucas: Perfect image. Now, what should investors and business owners do? First, recognize that the era of cheap money is structurally over. The cost of capital will remain elevated until debt to gdp ratios stabilize. Luna: So focus on efficiency and cash flow rather than leverage. Build businesses that don’t need constant refinancing to survive. Lucas: Yes. Diversify away from assets that are highly sensitive to interest rate changes. Look at sectors that benefit from inefficiency or fragmentation, where scale advantages matter more than cheap debt. Luna: And be patient. Wait for market dislocations to create entry points, rather than chasing growth at any cost. Lucas: Agreed. The game has changed. It’s no longer about how much you can borrow; it’s about how well you can operate with less of it. Luna: That requires a different kind of discipline. One that values resilience over rapid expansion. Lucas: Resilience is the new growth. And as we watch the Treasury auctions next month, keep an eye on the bid to cover ratio. If it drops, that’s a clear signal that the market is starting to price in the crowding out effect more aggressively. Luna: So we are watching the pulse of the economy, not just the headline numbers. Lucas: Always. Because the truth is rarely in the aggregate GDP number. It’s in the marginal decision of a CEO deciding whether to hire one more person or save the cash for debt service. Luna: And that decision ripples out to everyone else in the community. Lucas: Which is why understanding fiscal policy isn’t just for economists. It’s for anyone who wants to protect their future purchasing power. Luna: Smart preparation beats blind optimism every time. Lucas: Let’s leave you with this thought: as the debt burden grows, the definition of 'value' in our economy is shifting from quantity to quality. Are you building something that matters, or just something that fits the current credit cycle? Luna: That’s a question worth sitting with long after the episode ends. Lucas: Thanks for listening. We’ll see you in the next one.