Beware governments' post-doping malaise

Across the English speaking world, growth has failed to recover to pre-GFC levels. In these circumstances, a fetish for reducing government deficits risks triggering a modern version of the Roosevelt Recession.

Recent economic data from both the UK and US should have taken the wind out of the sails of those in the Anglosphere who – despite clearly contradictory evidence from mainland Europe – continue to argue that fiscal tightening is needed for economic growth is to recover.

The UK, which has followed a fiscal austerity path right from the election of the Conservative-Liberal coalition government in mid-2010, recorded a 0.3 per cent fall in the last quarter of 2012, while the US recorded a 0.1 per cent fall (mainly on the back of declining government expenditure). Getting the government sector out of the way and letting the private sector rip clearly isn’t going according to script, even when you can’t blame Brussels for the policy.

Coming five years after the start of the economic crisis, these results are also grinding in the message that the 2007/8 downturn was no ordinary post-WWII recession. In his final report in 2009, Bush’s chief economic advisor Ed Lazear expressed the hope that the depths of the downturn would presage a rapid growth spurt when it ended, since the Post-WWII pattern had been the deeper the downturn, the higher the rebound. He presented the following evidence in favour of this hope:

Figure 1: Lazear's "deep recession, strong rebound" argument from the 2009 Economic Report of the President


So much for that regression (which was dodgy enough when it was made – notice the clear time trend in the data for example). The peak-to-trough fall in real GDP from 2008 till mid 2009 was 4.7 per cent. If the post-recession rebound had fitted Lazear’s formula, economic growth from mid-2009 till mid-2011 would have averaged 6.5 per cent per annum. If it had even merely met the average for previous post-recession rebounds, growth would have been 4.6 per cent per annum.

Instead, it averaged 0.75 per cent per annum from June 2009 till June 2011, and just 1.25 per cent per annum for the whole three-and-a-half years since the US recession formally ended.

The most recent data has also killed any hope that the rebound was merely late in coming. Economic growth in the US has only briefly exceeded the 2 per cent per annum level at which sustained falls in unemployment have commenced in the past (reflecting 'Okun’s Law' that economic growth needs to exceed the sum of population and productivity growth for unemployment to fall), and now it appears headed down again.

Figure 2: US and UK growth rates


The situation is worse in the UK, which had a deeper downturn than the US during the depths of the crisis, and has only twice seen growth turn positive (using quarterly data; figure 2 uses annual change in nominal GDP minus CPI, and shows only one positive period). Talk of a "triple dip recession” hasn’t shaken the Tories from their fiscal austerity path yet, even though the polls indicate that, after almost three years in office, the electorate has given up on the belief that the Tories are best at managing the economy.

The situation is better in the peripheral Anglo-Saxon economies of Australia and Canada – better, but not different. Growth didn’t decline as much in the downturn, and the post-downturn recovery has been better. But growth hasn’t rebounded above pre-crisis highs, and is trending down in both economies.

Figure 3: Trend growth rates in the Anglo-Saxon economies


Five years – one half decade – after this crisis began, surely it is time for both politicians and conventional economists to accept that they don’t know what is going on, and to start listening to the economic heretics whose warnings of the approaching crisis they ignored?

Whoops, pardon me, just had to duck a flying pig.

Nonetheless, I’ll continue. As arguably the heretic-in-chief, my key proposition has been that this crisis was driven by a fundamental change in the behaviour of private debt. Every post-WWII recession has ended when private debt started to grow more rapidly than GDP – and in a trend that was ultimately unsustainable. I and a handful of others punted that this crisis would be the one where that unsustainable trend broke down, and a process of deleveraging would commence akin to that which caused the Great Depression.

The debt data now confirms that so far, that punt has proved correct. Some asset market development might yet temporarily reverse the trend – rising house prices in the US could conjure a return to leveraging by the household sector, for instance – but it appears that while actual deleveraging has been constrained, the days of private debt rising faster than GDP are over. Certainly, there has been no other post-WWII period in which private debt to GDP levels have fallen for as long as they have since the late 2000s.

Figure 4: Debt to GDP over the long term in the Anglo-Saxon economies


This is also why economic growth hasn’t recovered to pre-crisis levels: because the rate of growth of private debt hasn’t recovered. This is both a good and a bad thing. It’s good, because that rate of growth of debt relative to income wasn’t sustainable anyway: debt can’t indefinitely grow faster than income, and the period which we took as normal was in fact an abnormality that had to end. It’s bad, because with private debt now stagnant, economic growth will be too because – up to a point – a capitalist economy needs rising private debt if it is to grow.

This was something Hyman Minsky realised long ago, but which few economists since have appreciated:

"For real aggregate demand to be increasing … it is necessary that current spending plans, summed over all sectors, be greater than current received income," Minsky said. "It follows that over a period during which economic growth takes place, at least some sectors finance a part of their spending by emitting debt or selling assets."

I have formalised this in the argument that aggregate demand equals income plus the change in debt (and no, I’m not double-counting – and neither was Minsky). It’s a healthy phenomenon when that change in debt in turn finances productive investment. Unfortunately, for the last forty years, the lion’s share of that growth in debt has gone not into resurfacing Main Street, but lining the speculative pockets of Wall Street and The City.

Now we’re in an era where this relation tends to work in reverse. With either tepid debt growth or further deleveraging, investment is anaemic and expenditure lacks the impetus from rising debt that a growing economy needs. This is much of the explanation for why the UK and US remain becalmed five years after the crisis began.

The next Flow of Funds update, due in early March, may show a change in the trend, but at present the US appears clearly becalmed, with change in private debt essentially zero.

Figure 5: The start of the crisis is obvious when change in debt is considered


The UK, on the other hand, has its economic face to the wind with sporadic deleveraging reducing aggregate demand below the level of GDP for much of the last four years.

Figure 6: The UK is much more volatile but with a trend towards deleveraging


Australia is qualitatively different, but only because of a quantitative factor: private debt never stopped growing here, so demand has continued to exceed income alone.

Figure 7: Australia kangaroo-hopped out of trouble with renewed private sector borrowing


The same is true even more so of Canada .It continued to grow because the debt contribution to demand never turned negative, and its relative outperformance of the other Anglo-Saxon countries may simply reflect that its debt-driven component of demand remains larger than that of the other economies.

Figure 8: Canada continued borrowing its way to prosperity


In these circumstances, it’s – pardon the pun – depressing that politicians continue to obsess about rising government debt. Far from being the cause of the current malaise, as they seem to believe, the cash flow that government deficits inject into the economy is the only factor that is keeping private sector economic activity ticking over, and dissuading the private sector from deleveraging. I don’t see deficits to counter private sector deleveraging as either the sole or the ideal solution – private debt should be directly reduced as well – but reducing deficits via the fetish for government surpluses risks generating a modern version of the "Roosevelt Recession" by triggering private sector deleveraging in earnest.

The US was the only Anglo-Saxon country to experience outright private sector deleveraging in the crisis, with private debt falling from a peak of $US42.3 trillion in January 2009 to $38.9 trillion in June 2010. Since then it has flatlined – it was $38.8 trillion in September 2012. The danger of which politicians on both sides of the House are blithely ignorant is that attempts to reduce the government deficit – and thus slow the rate of growth of government debt – could cause the private sector to return to deleveraging again. Rather than stimulating the economy by getting the government out of the way, "fiscal consolidation” could renew "private consolidation” and push the economy back into recession, as it did in 1937.

Figure 9: The 'Rock of Damocles' of private debt overhanging the US economy


In the UK, the private sector merely stopped borrowing: there was no actual deleveraging. But the simple fact that the UK private debt bubble stopped growing has been enough to put its Ponzi economy into a permanent recession.

Figure 10: Damocles with Parkinson's disease


And then there’s my home town. The crisis caused an inflection in private debt, but it has since continued to rise – though more slowly than GDP.

Figure 11: Australia kangaroo-hopped its way out of deleveraging


I gave up on trying to locate government debt data in Canada’s Cansim database – if any reader can locate the series, please get in touch – but the aggregate private debt data implies that Canada has had such a good crisis because it hasn’t had one at all: private sector borrowing has gone on with the barest of slowdowns in its rate of growth.

Figure 12: Crisis? What crisis?


Of course I know that my argument, if it is heard by politicians at all, will fall on deaf ears – and that’s despite the fact that, for once, virtually all economists agree that government surpluses now would be a bad idea (though using very different arguments to mine).

It’s far easier for politicians to treat a nation’s accounts as no different than a household’s – and campaign about reducing government waste – than it is to comprehend the feedbacks that may cause fiscal consolidation to reduce aggregate demand by far more than it reduces the government deficit. So it seems we’re likely to have to relive the errors of 1937. Plus a change, I suppose.

Steve Keen is Associate Professor of Economics & Finance at the University of Western Sydney and author of Debunking Economics and the blog Debtwatch.

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