The Impact of Budget Deficits on Savings and Investment
How Fiscal Imbalance Ripples Through Capital Markets and Undermines Future Investment
We’re only halfway through FY2025 and the government is already running a budget deficit in excess of $1.3 trillion, or about a quarter of a trillion dollars more than the same time last year and almost double what it was three years ago. To make matters worse, the Congressional Budget Office (CBO) forecasts that our cumulative deficit (every annual deficit in the coming 10 years combined) for the coming decade will top $22 trillion. And this is the optimistic scenario—one in which the CBO assumes the 2017 tax cuts will expire on schedule, and there will be no economic crises, no global pandemics, and no serious wars over the next 10 years. Absent these assumptions, the actual cumulative deficit is likely to be closer to $30 trillion over the 10-year budget window.
The growth and persistence of deficit spending raises serious questions about how this fiscal recklessness will impact the broader economy. One pressing question is how recurring deficits will impact private investment by having an effect on national savings and the flow of foreign capital into the country.
The effect deficits have on national savings is most likely less than dollar-for-dollar. For example, if government cuts taxes by $1, it reduces public saving by $1, but it also raises the after-tax income of households by $1. Depending on the marginal propensity of households to consume, some of this windfall will be spent, but part of it will also be saved. If consumers typically spend 50 cents of a windfall, the remaining 50 cents will be saved. This case suggests that the $1 increase in the deficit leads to a 50 cent decrease in national saving (public saving + private saving [-1 + 0.5 = -0.5]). In an open economy, total savings can be rearranged from the national income identity in equation:
S = I + NX
The subsequent decline in national saving reduces the supply of funds available to private borrowers, which pushes up the interest rate for private borrowing. In the face of higher interest rates, households and businesses reduce private investment. Lower private investment means that the nation’s capital stock is smaller than it would be in the absence of deficit spending, reducing the standard of living for American households.
Higher interest rates also affect international capital flows. When domestic assets pay higher rates of interest, those assets become more attractive to both domestic and foreign investors. As a result, they draw in foreign capital, increasing demand for the domestic currency and causing it to appreciate against foreign currencies. A stronger currency driven by capital inflows attracted by higher interest rates leads to more imports and fewer exports. This is the natural counterpart to foreign investors financing the deficit: The capital account surplus is matched by a current account deficit.
This interplay between savings (S), investment (I), government borrowing (T – G), and foreign capital flows (NFI) can be captured in the national income accounting identity:
I = S + (T – G) – NFI
The degree to which increased federal budget deficits crowd out private investment depends on how much the reduction in public saving is offset by higher private saving and increased net inflows of foreign capital. If neither private saving nor foreign capital inflows rise sufficiently, higher government borrowing will raise interest rates and reduce private investment. For example, the CBO assumes that each dollar increase in deficit spending reduces private investment by between 15 and 50 cents, with a central estimate of 33 cents.
While the exact degree of crowding out varies across methodologies, countries, and time periods, the empirical literature consistently finds that large and persistent government deficits are associated with reductions in national saving and private capital formation.
Early international analyses, such as Edwards (1996), attribute low private saving rates in Latin America to fiscal imbalances, estimating a crowd-out rate of 55%. Masson et al. (1998) find a 25% to 40% offset globally, while for developed countries the effect ranges from 23% to 43%, depending on the specification. Haque et al. (1999), using Organization for Economic Co-operation and Development (OECD) data and advanced panel techniques, estimate crowd-out effects between 37% and 43%.
Several studies highlight the asymmetric nature of fiscal policy effects. Giavazzi et al. (2000) find that during normal times, the crowd-out rate is modest at around 10%, but rises to 50% during fiscal consolidations. Loayza et al. (2000) estimate that a 1% of GDP deficit expansion reduces private saving by 29% in the short run and by as much as 69% over the long run.
U.S.-specific studies report similar findings. Pradhan and Upadhyaya (2001) estimate a 41% crowd-out rate for the United States, and Sarantis and Stewart (2001) find a long-run crowd-out rate of 49%. Chinn and Prasad (2003) estimate effects between 31% and 38%, depending on whether they use cross-sectional or panel methods. De Mello et al. (2004) report a 23% to 36% crowd-out rate in the short run.
More recent work continues to find an association between budget deficits and reduced private savings and investment. Röhn (2010) estimates a 24% to 28% reduction in private savings for the U.S., and up to 44% internationally. Chinn et al. (2011) find that government borrowing reduces private saving by 48% in developed economies. Furceri and Sousa (2011) report crowd-out rate estimates ranging from 35% to 62%, depending on model specifications.
Financial market-focused studies yield similar conclusions. Gorton et al. (2012) and Krishnamurthy and Vissing-Jorgensen (2013) examine bond markets and find that government debt issuance crowds out private bond holdings by 17% to 57%. Ramey (2012), using instrumental variable techniques, finds government spending reduces private activity by as much as 71%.
Barro et al. (2014) estimate a 50% crowd-out effect tied to the demand for safe assets, while Boehm (2020) shows that government investment crowds out private investment by 56% after one year and 66% after two.
While not focused specifically on budget deficits, additional studies find negative crowd-out effects of public expenditure. Kim and Nguyen (2020) find that corporate investment declines by 30% to 72% in response to public spending, with instrumental variable estimates as high as 84%. Nguyen (2023) reports effects between 32% and 56% across developed country samples using FE-IV (fixed effects with instrumental variables) estimates and GMM (generalized method of moments) estimates respectively.
In sum, estimates on the magnitude of crowd out of budget deficits vary widely from as low as 10% to more than 70%. However, the bulk of estimates (74%) fall within the range of 20% to 50%, broadly consistent with the assumptions of the CBO. For the full sample of estimates, the mean and median crowd-out estimate from the economics research findings is 42 cents for every dollar increase in the federal deficit. This figure is slightly higher than the central estimate of the CBO, but still within its stated range.
The crowd-out effect is not simply an abstract theoretical concern. By running large and persistent budget deficits, the government diminishes the pool of capital available to future generations. Policymakers borrow today at the cost of tomorrow’s growth prospects. In other words, future economic abundance requires present fiscal prudence.