Fiscal cliff lessons from the '30s

During the Great Depression it was deficit spending that rescued the US. Today, it's quite possible the one thing Washington can agree on – that reducing debt is the number one economic objective – is a mistake.

The United States' so-called 'fiscal cliff' developed because both sides of the House concurred that reducing the rate of growth of government debt was the most important economic policy objective, but they could not agree on a common program to do so.

Instead, a program of indiscriminate spending cuts and tax concession abolitions was passed, as a 'Sword of Damocles' that would drop on America’s collective head if Congress could not reach a compromise by the end of 2012.

So unless a deal is bartered by December 31, a set of tax increases and across-the-board cuts in government expenditure will reduce net government spending by about $500 billion, or roughly 3 per cent of GDP.

What will the consequences be? As Mark Twain once observed, "The art of prophecy is very difficult, especially with respect to the future." but it’s fair to say that both Democrats and Republicans now fear what this future might be. The fantasy that reducing the government deficit might actually stimulate the economy – through a hypothetical mechanism that neoclassical economists christened "Reverse Ricardian Equivalence” – has clearly been abandoned, in the light of the tragic results of austerity programs in Europe. But both parties can see no other way to achieve their shared overarching objective of reducing government debt.

Pardon me for questioning bipartisanship in this fractious age, but it’s quite possible that the one thing Democrats and Republicans can agree on – that reducing government debt is the number one economic objective – is a mistake. A close look at the empirical data from America’s last great financial crisis – the Great Depression – implies that reducing government debt now may hurt the private sector far more than it helps it, and may also throw America back into recession.

My starting point is a proposition I’ve made many times before: that aggregate demand in a monetary economy is the sum of income plus the change in debt. I won’t go into the mathematics of this argument here; instead, I’ll show how this perspective explains why the Great Depression and our current economic crisis occurred. It also implies that the fiscal cliff could tip the US back into recession, while doing precious little to reduce government debt as a percentage of GDP.

Firstly, let’s get some perspective on debt. Which do you think is bigger – private sector debt, or public sector debt? With all the hullabaloo about how public debt is imposing a burden on our children, you’d be forgiven for nominating public debt as the bigger of the two. You’d be wrong: even after the growth of public debt and deleveraging by the private sector in the last five years, public sector debt is still less than 40 per cent of the level of private debt, as figure one shows (using data from the Federal Reserve Flow of Funds).

Notice also that private debt rose consistently and at an accelerating rate from 2000 until it peaked in 2009, and then fell sharply, after which it flatlined from 2010 on. In contrast, government debt flatlined across 2000-2004, rose slowly in 2004-2008, and only took off in mid 2008 – at the same time as the decline in GDP began.

Figure 1: Aggregate US Debt Levels and GDP


Now let’s look at the same data from the point of view of my argument that aggregate demand (or total cash flow in the economy) is the sum of GDP plus the change in debt. Figure two shows GDP and the annual change in both private and government debt, and it highlights two important points.

Firstly, the growth of private debt every year since 2000 was higher than the highest growth of public debt. In 2008, private debt grew by over $4 trillion dollars (when GDP was just over $14 trillion). Government debt rose by $2 trillion in 2009, which is a lot. But it was no more than the annual growth in private debt every year from 2000 till 2005, and less than half the peak level of growth of private debt of over $4 trillion in 2008.

Secondly, the growth of private debt changed dramatically very soon after the crisis began (the crisis is regarded as commencing on August 9, 2007, when the Bank National de Paris shut down three of its funds that were exposed to the US subprime market), but the 'fiscal crisis' – the sudden rapid increase in the government deficit – didn’t start for almost a year, when nominal GDP also began to fall. This already implies that the change in the behaviour of private debt played a key role in the crisis, and that government spending was simply reacting to the downturn in the real economy.

Figure 2: Annual change in debt and the level of GDP


Figure three brings this data together in the context of my argument that the change in debt adds to aggregate demand. The black line in figure three shows GDP alone; the red line shows GDP plus the change in private debt only; the blue line shows GDP plus the change in both private and government debt.

Now I think you can see both the timing and the severity of the crisis. The decline in private sector aggregate demand (the sum of GDP plus the change in private debt) began very soon after the credit crunch caused by BNP’s decision, and the scale of the decline in private sector aggregate demand was huge. Private sector aggregate demand peaked at $18.4 trillion at the beginning of 2008 and then plunged to $11.1 trillion by early 2010 – a fall of almost 38 per cent in total demand which caused unemployment to explode and asset markets to collapse.

The change in government sector debt cushioned the blow of this dramatic private sector collapse. Total aggregate demand in 2008 (the sum of GDP plus the change in both private and government debt) peaked at $18.8 trillion, and fell to $13 trillion – a 31 per cent fall in total demand. This is still a huge fall – greater than anything experienced since the Great Depression – but substantially less than the fall in private sector demand alone.

Since the depths of the crisis in 2010, the private sector has largely stopped deleveraging: private debt is neither rising nor falling, so that the change in private sector debt is having no overall impact on aggregate demand. But public debt, which is still rising, is adding over $1 trillion to spending in the economy at present. Without the public sector deficit right now, total cash flow in the economy would be roughly $15.5 trillion; because of the public sector deficit, total spending is closer to $17 trillion.

Figure 3: GDP plus the changes in debt


There is also the counter-factual issue of what would have happened to private sector aggregate demand if the government had not 'stepped into the breach' with the massive increase in its deficit. Clearly the private sector has stopped deleveraging now: would it have done so if the government had done nothing – either by keeping its deficit constant (as it was roughly doing until mid-2008), or by actively trying to run a surplus?

We can get some inkling of what could have happened by looking back at the Great Depression. Figures four to six repeat the analysis above for the period from the middle of the Roaring Twenties until 1945.

First, figure four shows that qualitatively the situation back then was very similar to today: a private debt bubble during the boom years which peaked when the crisis began in 1929, followed by declining debt and plunging GDP, and a rise in public sector debt. Quantitatively though, the story is very different.

Second, though private debt grew more rapidly than GDP during the boom years, its growth was slower than today and the debt ratio was also substantially lower: at the point at which private debt began to fall, the private debt to GDP ratio was 175 per cent, versus 303 per cent today. This implies that the private sector’s contribution to the crisis we are in today was actually stronger than it was during the Great Depression – so something else has to explain why the outcome then was so much worse than it has been today.

This leads to the second point: the decline in GDP during the Great Depression was much worse than today, it went on for far longer, and there was a 'double dip' back into declining GDP in 1937. Growth only began decisively as WWII approached.

Third, the initial decline in private debt went on for much longer. It started in 1929 and didn’t stop until 1934 – a five-year period of deleveraging versus only two and a half years this time.

Fourth, and crucially in the context of today’s fiscal cliff, there was a period of renewed deleveraging in 1937-1939, and this coincided both with declining nominal GDP as well (after it had grown strongly from 1932 till 1937) and a fall in the size of the government deficit.

Fifth, nominal GDP only began to recover strongly in 1940, when first private debt and then in 1941, government debt began to rise far more rapidly – clearly as a consequence of the war in Europe. Deficit spending, and not austerity, led the US out of the Great Depression.

Figure 4: Aggregate US Debt Levels and GDP 1925-1945


Figure five shows that the 'double dip' back into Depression in 1937-39 coincided with a fall in the level of the government deficit. The deficit had never been particularly large compared to today’s (as you can see by figure five to figure two), but from 1936 until 1938 the government deficit virtually disappeared – and so to did the economic recovery. It only came back in earnest when the government threw fiscal caution to the wind and geared up for the approaching conflict of WWII.

Figure 5: Annual change in debt and the level of GDP 1925-1945


As the end of WWII approached, rising public debt was such a large contributor to aggregate demand that the private sector was able to reduce its debt dramatically – far more so than during the worst of the Great Depression – with only a small impact on GDP.

Figure six puts the whole story together in terms of the contributors to aggregate demand.

Firstly, private sector debt drove the Roaring Twenties – and yet even though that age is now a byword for speculative excess, it had nothing on the period from 2000 till 2007.

Secondly, the initial government sector response to the crisis was anemic compared to today’s enormous stimulus. An increased government deficit did add to aggregate demand across the depths of the Great Depression, but it wasn’t until 1933 – three years after the crisis began – that the government deficit more than counteracted private sector deleveraging. For the whole period from 1930 until 1933, aggregate demand was less than GDP because private sector deleveraging more than countered the small increase in the government deficit during those years.

In contrast, as figure three illustrates, this time the speed of the government response was so fast and its scale so great that only for the year of 2010-2011 was aggregate demand less than GDP.

Figure 6: GDP plus the changes in debt 1925-1945


So is the fiscal cliff 1937 all over again? The history of the Great Depression implies that the fiscal cliff could not only reduce cash flow in the economy by of the order of 5 per cent of GDP, but it could also trigger a renewed period of private sector deleveraging that would reduce aggregate demand even more.

Steve Keen is a professor of economics and finance at the University of Western Sydney and author of Debtwatch and Debunking Economics.

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