Latest / The Fiscal Policy Podcast with Fexingo: Government Budgets, Stimulus, and Public Spending / How Public Debt Crowds Out Private Investment
Transcript
- Lucas: The most dangerous thing about government debt isn't the number on the spreadsheet, it's what that debt does to the rest of the economy. We call it the crowding out effect, and it happens when the government borrows so much that it drives up interest rates, making it harder for private businesses to get loans. Luna: Right, because if the government is eating all the available capital, companies have to pay more to borrow money for expansion or hiring. It turns a public spending problem into a private sector chokehold. Lucas: Exactly. And here is the concrete detail most people miss: it isn't just about the total amount of debt, it is about the timing. When the Treasury issues massive amounts of new bonds in a single quarter, it absorbs liquidity from the banking system. That pushes yields up across the board, including on corporate bonds. Luna: So even if the Federal Reserve tries to keep rates low, the sheer volume of government paper can force those rates higher anyway? That seems like a structural constraint rather than just a cyclical one. Lucas: It is structural. Think about it this way: every dollar the government borrows is a dollar that cannot be lent to a startup building a factory or a family buying a home. The demand for safe assets shifts toward government securities, which are perceived as risk-free, leaving less appetite for riskier private investments unless the return is significantly higher. Luna: Which means the government is effectively subsidizing its own borrowing costs by making private capital more expensive. Is there a tipping point where this becomes unsustainable for GDP growth? Lucas: There is no single magic number, but historians and economists point to periods where debt to gdp ratios exceeded sixty percent as the danger zone. In those eras, we see a measurable drag on productivity because entrepreneurs face higher hurdles to entry. Capital allocation gets distorted toward government projects rather than market-driven innovations. Luna: But wait, doesn't government spending also create demand? If they build a highway, that creates jobs and income. How do we separate the stimulus from the distortion? Lucas: That is the classic debate. Keynesians argue that during a recession, private demand is so weak that government spending fills the void without crowding anyone out. But we are not in a deep recession right now. In a near-full employment economy, every new government project competes directly with private enterprises for labor and materials. Luna: So the crowding out effect is stronger when the economy is hot. It makes sense that idle resources don't cause inflation or rate hikes, but active ones do. Lucas: Precisely. And let us look at the mechanism through which this hits the average listener. When Treasury yields rise, mortgage rates follow. Homebuyers face higher monthly payments, which cools the housing market. That reduces consumer spending, which further slows economic growth. It is a chain reaction. Luna: I never thought about mortgages being directly tied to Treasury auctions. It feels abstract until you realize your rent or mortgage payment just went up because of some bond sale in New York. Lucas: It is incredibly tangible. And it goes beyond housing. Corporate bond yields move in lockstep with Treasuries. If a company needs to issue debt to fund a new R&D lab, and their borrowing cost jumps by fifty basis points because of increased government supply, they might delay that project entirely. Luna: Delaying innovation sounds like a slow-motion disaster. Are there examples where this actually happened recently, or is it mostly theoretical? Lucas: We saw hints of it during the post-pandemic recovery phase. As the government injected trillions into stimulus while simultaneously issuing record debt, we noticed a divergence. Large-cap stocks held up, but small-cap innovation struggled to access venture capital. VCs became more cautious because the risk-free rate was rising, making their potential returns look less attractive by comparison. Luna: So the risk-free rate acts as the baseline for all valuation models. If that baseline moves up, everything else has to work twice as hard to justify an investment. That changes the entire calculus for founders. Lucas: It does. And it forces companies to focus on short-term profitability over long-term growth. When capital is cheap, you can afford to lose money for five years while you build a platform. When capital is expensive, you need profits yesterday. That shrinks the horizon of business strategy dramatically. Luna: That sounds like a fundamental shift in corporate culture driven by macroeconomics. I wonder if executives even realize how much their strategic choices are dictated by Treasury auctions. Lucas: They definitely feel it in their CFO offices. Every time the Department of the Treasury announces a new issuance schedule, treasury departments at major corporations adjust their hedging strategies. They know the game. They just have to play within the constraints the government sets. Luna: It feels like the government is playing checkers while everyone else is trying to play chess. The rules change based on their borrowing needs. Lucas: Well, it is worse than checkers. It is more like the government owns the board. And while they manage their own liabilities, they inadvertently impose a tax on private sector efficiency. That tax is invisible, but it shows up in slower wage growth and fewer job openings. Luna: So the solution isn't necessarily austerity, but better timing? Maybe borrowing less when the private sector is strong? Lucas: Counter-cyclical fiscal policy is the textbook answer. Borrow heavily during downturns when private demand is collapsed, and run surpluses during booms to pay down debt. But politically, that is almost impossible to sustain. Leaders want to spend when they are popular, not when the economy is overheating. Luna: Because spending buys votes, but paying down debt doesn't. It is a political reality that undermines the economic theory. Lucas: Exactly. And that is why we see persistent deficits even in good times. The political incentives are misaligned with the economic necessities. We end up with a steady state of high debt that gradually erodes the productive capacity of the nation. Luna: It reminds me of compound interest, but in reverse. Instead of wealth growing, opportunity shrinks bit by bit every year. Lucas: That is a perfect way to put it. And the worst part is that we rarely notice it happening. It is not a crash. It is a slow leak. By the time the data clearly shows declining private investment, the damage to the ecosystem may already be done. Luna: So what should listeners watch for? Is there a leading indicator that suggests crowding out is starting to bite? Lucas: Watch the spread between corporate bond yields and Treasury yields. When that spread widens unexpectedly, it signals that investors are demanding a higher premium for private risk, often because they are saturated with government paper. Also, look at small-business loan volumes. If those drop while government borrowing rises, you are seeing the effect in real time. Luna: Those are specific, actionable metrics. Much better than just staring at the national debt clock. Lucas: The debt clock is dramatic, but it is misleading. What matters is the flow of capital, not the stock of debt. If the government borrows efficiently and invests in high-return projects, it can sometimes crowd in private activity. But when they borrow to fund current consumption, it is purely a drain. Luna: Distinguishing between productive and unproductive debt is key. Most people don't make that distinction though. Lucas: True. And until they do, we will keep seeing these inefficiencies. It is a lesson in fiscal discipline that America seems reluctant to learn. Luna: Maybe because the pain is distributed too widely to blame any single policy. Lucas: Perhaps. But the economics don't care about our political preferences. The market always finds a way to price in the risk. Luna: So next time you see a headline about a new infrastructure bill, ask yourself who is paying for it and what opportunities are being passed over. Lucas: That is the right question. Because behind every public promise, there is a private cost waiting to be paid. Luna: If walking through the economy with us has made something click, consider supporting the show directly. Honestly, if today was worth a coffee to you, that's the link — buy me a coffee dot com slash fexingo. Lucas: Your support keeps this ad-free and allows us to dig deeper into these complex topics without rushing. Thank you for keeping the conversation going. Luna: Yeah, it really helps us stay independent and focus on the details that matter most to your financial literacy. Lucas: Let us circle back to that spread between corporate and government bonds for a second. You mentioned earlier that widening spreads signal trouble. Luna: Right, because it shows investors are nervous about private credit relative to the safety of Treasuries. Lucas: And when that nervousness spikes, it usually precedes a correction in the stock market. Equity valuations rely on stable discount rates. If those rates become volatile due to fiscal uncertainty, bubbles tend to burst. Luna: So fiscal policy isn't just about budgets, it is about market stability. One affects the other directly. Lucas: Always. Ignoring that link is how we get surprises. And in finance, surprises are expensive. Luna: Expensive, yes, but avoidable if we pay attention to the signals. Lucas: Agreed. The data is there. We just have to be willing to read it. Luna: Do you think younger investors are more aware of this dynamic than older generations? Lucas: Interesting question. Younger investors grew up with high debt levels, so they might be more attuned to the risks of leverage. Older investors remember the era of low rates and might be slower to adjust their expectations. Luna: Generational experience shapes risk perception. That explains a lot about current market behavior. Lucas: It does. And as the older generation passes wealth, those low-rate biases will fade. We might see a structural shift in how capital is allocated across the board. Luna: A reset of sorts. Hopefully a healthy one. Lucas: Healthier for the economy, certainly. Whether it is comfortable for everyone remains to be seen. Luna: Comfort is rarely a sign of growth, though. Lucas: No, it usually isn't. So maybe discomfort is the price of admission for a more efficient future. Luna: An interesting way to frame the transition. I like that perspective. Lucas: Good. Let us hope we can navigate it without causing too much collateral damage along the way.