An indirect cost of record public debt: crowding out market competition?

[by Peter Ormosi] When Rishi Sunak announced the fourth Covid related support package in October 2020, UK government debt had already been at the unprecedented level of £2 trillion, exceeding 100% of the country’s GDP for the first time since the 1960s. But whereas the main worry on Sunak’s mind right now must be the likely interest rates on the national debt, the related risks, and to keep finances flowing, one should not dismiss the importance of how high government debt is likely to affect the real economy. This short blog considers some little-discussed side-effects that could have a long-term impact on competition.

When governments turn to credit markets, they often compete with private borrowers for loans, thus crowding out private investment. Crowding out can impact market competition in several ways. For example, the increasing cost of borrowing might increase the cost of new investment thereby contributing to increased entry barriers especially in credit constrained environments. There are numerous studies that have established the role of credit constraints in market entry. Such constraints are often more binding on small firms and on firms in sectors that are more dependent on external finance [1]. Concentrated markets, where incumbent businesses are likely to be realising large rents, are more supportive of the incumbents’ ability to reinvest optimally, irrespective of the exact changes in funding conditions [2]. On the other hand, potential entrants, who are more susceptible to changes in credit markets will be more vulnerable and will face higher entry barriers if the cost of borrowing increases. At a time of increasing market power across numerous industries, such weakening of potential competitors can have long-lasting negative effects on competition.

Another likely source of financial risk is inflation. With having to pay back billions in interest rates, it might be tempting for the Government to allow inflation to pick up pace and inflate some of the debt away. But reduced price-stability can be harmful in product markets. For me one of the most important of these is the increased levels of misperception as inflation muddles the price signals necessary for well-functioning markets –  lot depends on how much businesses can anticipate inflation to improve their judgement of whether a price increase is a sign of extra profit or just inflation. Moreover, the increase in shoe-leather costs (the effort by firms and individuals to minimise the effect of inflation on the diminishing purchasing power of money), and menu costs (the direct cost firms incur from changing prices) lead to larger fixed costs which disproportionately favour large incumbent businesses. These are not purely speculative hypotheses. The impact of inflation on market power has been documented in a number of studies (see for example [3]).

A third issue is increased taxes as a potential response to the increased level of public debt. Here a lot depends on what kind of taxes the Government will prefer. Increasing corporate taxes would further exacerbate the relative cost disadvantage of potential competition (when compared to incumbent businesses) especially where the incumbents already have strong market power (previous research has found that in concentrated markets, corporate  ad valorem taxes are more efficient and lead to higher consumer welfare [4]). Adding to this, it is also likely that new entrants are less in the position to operate internationally to avoid new taxes, or if reform of business rates is delayed it would perpetuate the bias in favour of online business.

The above changes (crowding out, ,increased inflation and taxation) could impact product markets in other ways too. Take innovation first. Innovative firms are more exposed to changes in the cost of borrowing simply given the increased level of investment that R&D requires, which would mean that the increased public debt is likely to harm more innovative firms more through crowding out private R&D investment,[5] especially in sectors that depend more heavily upon external finance [6].

Changes in taxation are likely affect consumer behaviour as well. At the time of writing this blog, there is some speculation that an increase of the basic income tax rate to 21% is a likely scenario, which would reduce the spending power of consumers. This, and the rising prices triggered by Brexit will create millions more cash constrained households. There is some possibility that these consumers will engage more with markets to seek out the best deals, thereby intensifying the competitive pressure on firms. Or as inflation increases price dispersion, making consumers search more for low prices, would in turn intensify market competition, but at the same time increase search costs (see for example [6]).  But the opposite might also happen, where the same constraints would reduce consumers’ willingness and ability to shop around.

To conclude, many of the concerns listed above relate to a potential crowding out effect of large government debt. Analysts who are sceptical about the existence or the magnitude of crowding out effects would claim that such effects did not follow the hikes in debt-to-GDP ratio following the financial crisis. However, we must not forget that the magnitude of borrowing in 2020 has reached unparalleled levels so the market response might also be largely unprecedented. Certainly, a lot hinges on the Government’s ability to avoid dampening the investment incentives of businesses.

Note on crowding out: The gravity of the above effects depend on the details of how fiscal and monetary policies evolve. At the moment, the cost of government borrowing is unprecedentedly low (as in borderline negative rates). This suggests that there are ample investment funds to suck up even as much as the £350billion government bonds released this year. This suggests that markets are seemingly not much worried about this level of borrowing. The question is, how much of this funding is competed away from private sectors. Moreover, when the Government borrows money, competition for credit increases, raising the price of private sector borrowing (the interest rate) for private investors. At the moment we don’t know how long the borrowing will continue, and that will certainly impact the magnitude of crowding out. Other changes are likely to have a similar effect. Today’s peculiarly low bank rate triggered the Government to start switching some of its existing (high interest) debt into short-term loans borrowed from the private sector at the bank rate. This behaviour can further contribute to crowding out by impacting the rate charged to riskier private businesses.

[1] Aghion, P., Fally, T., & Scarpetta, S. (2007). Credit constraints as a barrier to the entry and post-entry growth of firms. Economic policy, 22(52), 732-779.

[2] Aghion, P., Farhi, E., & Kharroubi, E. (2019). Monetary policy, product market competition and growth. Economica, 86(343), 431-470.

[3] Chirinko, R. S., & Fazzari, S. M. (2000). Market power and inflation. Review of Economics and Statistics, 82(3), 509-513.

[4] Anderson, S. P., De Palma, A., & Kreider, B. (2001). The efficiency of indirect taxes under imperfect competition. Journal of Public Economics, 81(2), 231-251.

[4] Croce, M. M., Nguyen, T. T., Raymond, S., & Schmid, L. (2019). Government debt and the returns to innovation. Journal of Financial Economics, 132(3), 205-225.

[5] Aghion, P., Askenazy, P., Berman, N., Cette, G., & Eymard, L. (2012). Credit constraints and the cyclicality of R&D investment: Evidence from France. Journal of the European Economic Association, 10(5), 1001-1024.

[6] Benabou, Roland. “Search, price setting and inflation.” The Review of Economic Studies 55.3 (1988): 353-376.

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