Crowding-out Hypothesis in a Vector Error Correction Framework: A Case Study of Pakistan

Under the umbrella of the IMF stabilisation programmes, Pakistan has pursued a policy of fiscal consolidation since 1988. A look at the budget deficit from 1988 onwards reveals that the policy has only been marginally successful. Even this fragile accomplishment of the Fund-based programme has been achieved at a much greater cost: the reduction in budget deficit has only been materialised because of the curtailment of development expenditure component of total fiscal outlays [Social Policy and Development Centre (2001)]. Economic theory suggests that development expenditure component of fiscal outlays, which also equals net investment by the public sector,1 has a significant relationship with both the rate of private investment and economic growth. If public investment increases, fewer funds will be available for private investment. Competition will thereby drive the interest rates up leading to lower level of private investment. Neo-classicals believe that this process will only result in a redistribution of gross national between the public and the private sector and the rate of economic growth will remain intact. On the other hand, Keynesians argue that the multiplier effect of higher public spending will be larger as compared to the induced negative effect of reduced private investment on the rate of economic activity and, therefore, gross national product will increase.