“Crowding out” is an effect claimed to occur when governments run deficits and have to borrow to finance the deficits. It refers to the government using funds via borrowing that otherwise would go to private borrowers. Hence, they are “crowding out” the private borrowers.
In normal times, when government deficits are small relative to the economy, crowding out probably has little effect. Today, deficits are huge and the reality of crowding out is real.
Why can’t private firms “crowd out” the government? Private firms must make a profit. When they don’t they disappear (unless they are favored by the Government and get bailed out). If the interest rates private firms have to pay for new funds rises, it makes fewer investment opportunities possible. Governments do not have a profit constraint and have access to a printing press. If interest rates rise, so be it. They can and will keep on borrowing.
Businesses and consumers are claiming they cannot get credit. Some do not deserve it, but many do. The Fed has pumped enormous funds into the banking system but these funds are not being used to make loans. Loans outstanding are declining. So, what is happening? Some of the funds are being held as excess reserves (i.e., banks do nothing with them) and some are being used to finance the Federal Government deficits (an indirect way of QE). According to James Turk:
If we mark the beginning of the financial crisis with the collapse of Bear Stearns in March 2008, data from the Federal Reserve show that since then bank lending has declined by $220 billion. During this same period, banks increased the amount of US government paper they hold by $337 billion.
Turk further argues that what is going on is harmful to the economy in the intermediate to long term:
Instead of depositor money being used to stimulate economic activity in the private sector by lending to businesses and consumers, the banks are helping to fund the growing federal deficits. This re-allocation of resources has a negative long-term impact on the economy. Depositor money is not being used for productive purposes like building manufacturing plants and making other investments that will create jobs and grow the economy.
As we become more like Greece, perhaps banks would have stronger balance sheets with loans to the private sector rather than US Treasuries. Things have gotten that bad that such a scenario may not be that far off.