I should point out that I have already written an article specifically about the crowding out effect, and the circumstances under which it dominates, so click the link for details on that.
As indicated above, the key point relates to what influence any increase in government spending has upon the prevailing interest rate (and also the price level), because that will determine whether or not net private sector investment is being discouraged by higher costs.
Potential Government Actions
Depending on the level of economic development that already exists in a country, there will be a greater or lesser potential for some beneficial extra spending by the government. In the rich developed world we may take for granted many of the institutions and opportunities that support private enterprise and a high standard of living, but many of these institutions are severely lacking in poorer countries.
For free markets to truly flourish, the following must be in place:
- Key Infrastructure Projects - roads, rail, airports, seaports, bridges & dams
- Key Resources - food & water, energy, raw materials, supply-chains
- Law & Order - policing, civil and criminal courts, private property rights
- Key Institutions - healthcare, education, basic banking facilities
- Female Emancipation - contraception and equal rights
Governments usually play a vital role in ensuring these things, and without them there is little opportunity for individual people to prosper regardless of their potential.
Net Crowding Out
In an advanced economy, the key determination on whether or not it makes sense to increase government spending comes down to whether or not there are significant idle factors of production that can be spurred into action.
Unless there is plenty of spare capacity in the economy such that output can increase without causing interest rates and prices to rise (i.e., where the economy is operating on the flat section of the aggregate supply curve), then it is likely that the crowding out effect will dominate the crowding in effect and productivity will end up suffering.
Government is highly inefficient, and in most circumstances public sector officials are in no way better at spending taxpayers money than the taxpayers are at spending it themselves. However, just as in the developing world, there are exceptions to this rule. The need for national infrastructure projects, or the maintenance and upgrading of existing infrastructure, is usually the most promising avenue for increased government spending.
Most of the controversy arises over the proper role of government in managing the economy during economic downturns. First impressions might lead us to think that stimulus spending policies should always be desirable when the economy heads into a recession. However, in all but the most severe downturns in the business cycle, a strong argument can be made that leaves little scope for beneficial government intervention. The net crowding in effect will usually be dominated in most cases, but see 'The Crowding Out Effect' for a full explanation.