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Issue 14/21 October 2009

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Today’s Issue Includes:

1) Budget deficits, ‘crowding out’ and ‘crowding in’ by Nigel Tree


The UK government is running a budget deficit this year which is estimated officially at £175bn but could be anything up to £200bn. The UK has been at the forefront of persuading nations that the way through the credit crunch is to run a deficit, prime the fiscal pump and spend big, in order to offset the effects of negative economic growth. But what are the likely implications of such a policy. To see this we need to go back to traditional textbook theory.

Understanding crowding out

Firstly, let’s look at the traditional theory of crowding out. When government’s run budget deficits they have to borrow money and this tends to push up interest rates. Investment is a negative function of the interest rate, thus higher interest rates will tend to lower private sector investment. The amount of investment made today will determine the future stock of a country’s capital and thus the size of potential GDP. In other words, a budget deficit will tend to reduce investment and inhibit economic growth.

This is backed up through the transmission mechanism by which the government borrows money. This works by government selling bonds in the open market. These bonds will be competing with other financial instruments in the private sector for the supply of funds which are available. When savers opt to lend to the government from their pool of savings, then the amount left to lend to the private sector is reduced. The result of this is that private sector investment is crowded out.

On top of this, a current deficit will increase debt which must be paid back later, which will result in higher taxes or lower spending or both.

However, this supposes that the volume and flow of savings is in fact fixed. In reality, what may occur is that as governments spend more, output and incomes are raised, and since saving is a positive function of income we could expect more saving. Thus more funds will be available to the private sector as well as the public sector.

Crowding in – the alternative

Not only is saving a positive function of income, but investment is also. So as the government expands the economy at a time when there is an output gap by borrowing more and increasing government spending, there will be a multiplier effect on income. As incomes increase, spending on goods and services will increase and firms will find it necessary to increase investment. Thus additional government spending will have an induced effect on investment. This means that there could be a ‘crowding in’ effect.


Running a government deficit could lead to crowding in.

Therefore, we have two possible effects working in opposition to each other. On the one hand, a fiscal deficit raises interest rates and crowds out investment. On the other hand, by pushing real economic growth to a higher level than it would otherwise have attained in the short run, government deficit-financed spending will push aggregate demand outwards, especially in an economy with unemployed resources.

So what can we expect?

Are we in a situation where we are looking at a trade off between spending now and paying the costs later on? Not necessarily. Running such a fiscal stimulus when there is a small output gap would be crazy. But does the same logic hold in the present circumstances?

Nobel prize winner, Paul Krugman, argues that the same logic does not hold now. That is because we are currently in a liquidity trap where monetary policy is being hindered. Governments would like to lower interest rates in the current circumstances but they are already so low that there is nowhere to go. Thus fiscal expansion is the only option.

Although such expansion will rack up debts for the next generation, these will not be on a one-for-one basis. Since higher spending raises GDP and leads to higher tax revenue, this results in a significant amount of the original borrowing being offset. Krugman suggests that there could be as much as a 40% offset. In other words, a £100m stimulus may only lead to an extra £60m in additional debt.

Also, given that the main determinant of business investment will be the state of the economy, it follows that anything which improves the economy will improve investment and thus leads to crowding in.


Although crowding out is the traditional result of running a government deficit, in the current situation in the UK, US and many other countries, such a deficit could lead to a crowding in of investment expenditure.

In fact a recent analysis by the IMF says that: “The evidence suggests that economies that apply countercyclical fiscal and monetary stimulus in the short run to cushion the downturn after a crisis tend to have smaller output losses over the medium run.”

It can be argued that in the circumstances we now find ourselves in, the demand side is more important than the supply side. Of course, eventually the supply side will become more dominant as the output gap diminishes and crowding out will again take place if governments try to run budget deficits.

Krugman goes even further and argues that “…the worst thing we can do for future generations is NOT to run sufficiently large deficits right now.”


Charles Bean, Deputy Governor for Monetary Policy at the Bank of England has just given a fascinating talk on Quantitative Easing. He gives an A,B,C guide as to how the process works in practice.

Altogether a very useful insight.

To access it click here:


2) Running out of energy? Tell me about it by Nigel Tree


“Simply maintaining global production at today’s level would need the equivalent of a new Saudi Arabia every three years.” So says a new report by the UK Energy Research Centre (UKERC). The report argues that conventional oil production is likely to peak before 2030, with a significant risk of a peak before 2020. It concludes that “the UK government is not alone in being unprepared for such an event – despite oil supplying a third of the world’s energy.”

Why do we have a problem?

According to the UKERC report there is an increasingly rapid decline in oil production from existing fields. More than two-thirds of current crude oil production capacity may need to be replaced by 2030 to prevent production from falling.

The development of new oil fields has been hindered by the credit crisis and the fall in the price of oil last year. This led to some projects being delayed and others suspended. However, oil prices this year have already recouped some of the losses of 2008 and are now well over the average price for the past ten years. Also, according to the IMF in their recent World Economic Outlook, the costs of oil investment have also declined in recent quarters, which should support exploration and development.

The fall in demand during the current recession has limited price rises and depressed exploration, but the concern now is what is going to happen as world demand returns. If oil supply is not sufficiently flexible it will put great pressure on price. According to the IMF: “The main supply-side concerns, however, continue to be oil investment regimes and geological constraints. First, the deterioration in incentives provided by investment regimes in some producer countries remains a concern. Second, new oil fields are smaller in size and present greater technological and geological challenges, and the decline rates of many existing fields have risen by more than expected. As a result, more investment is needed just to maintain current capacity.”


World energy supply is becoming increasingly insecure.

Effects on the UK

The UK is not only dependent on oil but on imported gas as well. A report last week by Ofgem, the energy regulator, said that up to £200bn was needed in investment to secure supplies as well as meeting carbon targets. Ofgem pointed out that recent events such as the Russia-Ukraine gas crisis has raised concerns about the security and price of gas supplies when many countries in Europe were becoming more and more dependent on imported energy. The report said that a combination of older nuclear plants being decommissioned and the closure of coal and oil plants in the UK by the end of 2015 could “pose a threat to security of supply.”

Ofgem put forward four scenarios for the future provision and security of UK energy and also highlighted a number of risks:

  • Britain will face significant levels of gas imports, in particular for gas power plants to replace lost nuclear and coal-fired capacity. This increases our exposure to uncertainties in the global gas market, supply disruptions and potential price increases.

  • Significant changes in the way in which we generate and consume power may be needed to manage the variability associated with increasing reliance on wind power.

  • Given the massive levels of investment needed, there is a high likelihood of rising consumer bills, especially if oil and gas prices continue their underlying rise since 2003.


Security of energy supplies is going to become an increasing problem for the global economy. Not only are there security problems but the volatility of supply will also have serious implications on prices. As far as the UK is concerned, Ofgem is looking at a spike in domestic energy bills of between 14% and 25% by 2020 from today’s levels, although if one of its scenarios takes place it could lead to rises of up to 60%.

There are important decisions which the next government is going to have to make. How are they going to juggle the UK’s energy demand with insecure gas and oil supplies and volatile prices. Should we opt for greater nuclear capacity or is there scope for renewables to fill part of the gap? What is clear is that time is running out and decisions need to be taken soon. The lights may actually go out before the last person leaves!


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