Almost five decades ago, a notable book emerged concerning the UK economy, making significant waves. Titled Britain’s Economic Problem: Too Few Producers, the book originated from a series of articles penned by authors Robert Bacon and Walter Eltis for The Sunday Times in November 1975. This predates my time, but its impact resonates today.

Bacon and Eltis, both esteemed professors from Oxford, argued that an excessively large public sector, which they referred to as the “non-market” economy, was overshadowing the private sector, or the market economy.

The insights from the articles and the book were particularly relevant during a period when the UK teetered on the edge of an embarrassing bailout from the International Monetary Fund, partly due to the oversize public sector. Contemporaneous estimates, some official, indicated that public spending represented about 60 percent of gross domestic product—although that figure was somewhat inflated, the actual number stood at 46.5 percent in 1975-76, a threshold that remained unattained for 45 years until the disruptions of 2020-21 caused by Covid-related spending surged it briefly to 53.1 percent.

The idea of crowding out gained traction as a popular economic concept in the latter part of the 1970s, aligning closely with the economic philosophy of Margaret Thatcher, who found it compelling. Tragically, Eltis has since passed away, but he was appointed director-general of the National Economic Development Office, “Neddy”, in the late ’80s.

However, by that time, economists had largely moved away from the discussion of crowding out. The persistent high unemployment rates of the 1980s and early 1990s indicated sufficient spare capacity in the labor market, allowing both public and private sectors to flourish.

During the Thatcher era, the public sector significantly contracted due to extensive privatizations, with public spending dipping below 40 percent of GDP in the mid-1980s and remaining there for two decades.

Today, concerns surrounding crowding out have resurfaced and were prominently highlighted in the recent analyses and forecasts released by the Office for Budget Responsibility (OBR), alongside Rachel Reeves’s inaugural budget. The concept of crowding out was mentioned 16 times in the OBR’s Economic and Fiscal Outlook.

The OBR expresses apprehension that Labour’s proposed expansion of the public sector could suffocate private sector dynamics. While public spending is projected to remain below the 1975-76 levels, it is anticipated to exceed 45 percent of GDP over the next three years.

In summarizing the budget’s economic implications, the OBR stated: “Budget policies deliver a temporary enhancement to GDP in the immediate future, accompanied by some crowding out of private sector activity in the medium term.”

Further elaborating within its report, the OBR predicts a 0.6 percent decline in business investment as a share of GDP from 2023 to 2029, attributing this to the anticipated crowding out caused by increased government spending and net fiscal loosening.

This situation prompts a critical examination: what is transpiring, and should there be serious concern? Traditionally, crowding out is categorized into two forms. The first is “resource” crowding out, which occurs when the public sector monopolizes resources that could have been utilized by the private sector to foster growth. The pressing issue now involves labor resources, particularly in construction. With unemployment rates remaining low and economic inactivity higher than pre-pandemic levels, many companies are facing labor shortages.

The second type is “financial” crowding out, where an expanded public sector complicates borrowing for private sector expansion. The OBR warns that this may also transpire.

According to the OBR, “We perceive that the [fiscal] loosening aligns with a slightly elevated trajectory for interest rates compared to our previous forecasts, propelling both Bank and gilt rates up by a quarter of a percentage point across all maturities.” Increased interest rates, they assert, will bring demand into equilibrium with supply throughout the forecast period, contributing to the crowding out of business investment by escalating the cost of capital.

Is the OBR justified in issuing warnings regarding crowding out? It grounds its assertions well when discussing available resources, especially labor availability. The construction sector has consistently alerted about labor shortages, worsened by the aftereffects of Brexit, estimating a need for an additional quarter of a million workers by 2028. Labour’s ambitious target of constructing 1.5 million new homes during this parliamentary term, alongside efforts to restore hospitals and schools and other infrastructure investments, faces significant challenges, potentially impacting the private sector.

In response, the government would argue that it is determined to boost labor supply by reducing the number of economically inactive individuals, currently at 2.75 million, often due to prolonged health issues. Some of these issues are linked to long NHS waiting times, which Labour has prioritized addressing. However, sustaining a steady influx of youth into sectors like construction remains a considerable challenge.

Conversely, the OBR’s assertions about financial crowding out remain less robust. It reflects anxieties from the market, concerns that have started to subside, over whether this budget will delay the Bank of England’s ability to lower interest rates. Current forecasts suggest that the Bank will likely reduce interest rates by a quarter-point to 4.75 percent on Thursday, making the accompanying guidance crucial to understanding its implications.

The projected quarter-point change in interest rates remains negligible and shouldn’t consequently hinder private investment. Higher impacts might indeed strengthen the OBR’s arguments. Ultimately, the budget’s direction was anticipated to stimulate private investment rather than suppress it.

David Smith is the Economics Editor at The Sunday Times.

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