Posted by Joseph Y. Calhoun, III

One of the objections that I and others have made about Keynesian spending plans is the crowding out effect. This effect refers to any reduction in private investment or spending that occurs because of the increase in government spending. The Keynesians assure us that this isn’t a problem because the private sector is not willing to borrow and spend right now. That may be true, but it is damn hard to prove. One thing we do know now is that banks are increasing their holdings of US Treasury securities:

Aug. 3 (Bloomberg) — U.S. lenders bailed out by the government are returning the favor by stepping up purchases of Treasuries, helping to temper a rise in borrowing costs.

Bank holdings of U.S. government securities are up 15.6 percent from a year ago, almost double the average annual growth rate of about 8 percent since the Federal Reserve began tracking the data in 1973, according to the Greenwich, Connecticut-based trading and research firm MKM Partners LP. Purchases may accelerate as lenders look for places to park rising deposits as sales of federal agency debt of companies such as Fannie Mae and corporate bonds slow.

“We expect demand to shift to Treasuries, given low net supply in corporates,” Srini Ramaswamy, a fixed-income strategist at New York-based JPMorgan Chase & Co., the second- biggest U.S. bank, wrote in a report July 24. The firm’s models “suggest that bank purchases of corporates and mortgage-backed securities will be small relative to the growth in deposits net of loans, which have been growing at a rate of roughly $29 billion per month.”

Now, this doesn’t prove that US government issuance is crowding out corporate issuers or other borrowers. The issuance of corporate debt has fallen as companies have deleveraged so it could be that the banks are buying the Treasuries because they don’t have anything else to buy. But consider the following: What would the banks be doing with all those deposits if the government debt wasn’t available as an investment? They can’t just pay out on deposits without loaning money to someone; if they take deposits and don’t make loans with those deposits at rates higher than the deposit rate, they lose money. We cannot know what loans would have been funded because the presence of the government debt allows them remain profitable while not making new loans to anyone other than the government. So is there a crowding out effect? Yes, as long as the government debt market exists at all, there is a crowding out. Whether there is additional crowding out due to the increase in the deficit cannot be determined, but things might be quite a bit more interesting right now if banks were out there competing for borrowers rather than pushing a button and buying more Treasuries. Or going out of business which might not be a bad outcome either.