Do budget deficits crowd in or crowd out private investment: evidence from Europe

The impact of budget deficits on private investment is an unsettled issue. If budget deficits are to be financed by borrowing, interest rates must rise so that capital markets can reach equilibrium. High interest rates, in turn, result in a decreased investment, hence the crowding-out effect. On the other hand, if budget deficits help boost economic growth, investors could become more optimistic and decide to invest more, hence the crowding-in effect. Finally, if an increase in deficits due to tax cuts today is to be matched by tax increases in the future, interest rates and investment may not change. In this paper we employ cointegration analysis and data from nine European countries to test the impact of budget deficits on private investment.