As the chart below, taken from Australian economist Steve Keen’s blog, shows, the early years of this downturn have been marked by massive government intervention. By contrast, in the immediate aftermath of the 1928/29 economic peak there was relatively little government stimulus to boost economic demand.
Putting figures on it, by 1930 government borrowing had added a mere 1.2% to aggregate economic demand when compared with 1928 levels. The chart shows this in the form of minimal divergence between the two red lines in the first two steps from left to right along the x-axis. This time around, there’s been a huge 12% boost to aggregate demand in the first two years of the recession (2008-2010) as a direct result of government borrowing and spending, largely offsetting the 15% fall in demand from the private sector’s deleveraging. Compare the two diverging blue lines on the chart to see this.
On a sobering note, we’re starting from a position this time around (when compared with 70 years ago) where the economy has been much more reliant on borrowing in order to grow. Keen calculates that “the debt contribution to demand began at a far higher level this time than last, peaking at 22% in 2008 versus at 8.7% in 1928. On this basis, the fall in aggregate demand caused by private sector deleveraging today is more rapid than in the 1930s, has not reached the maximum rate sustained during the Great Depression, and shows no signs of abating.”
Can governments continue to fill the gap caused by private sector retrenchment? The evidence would suggest not. This year’s turbulence in government bond and credit markets tells us that investors are drawing the line at supporting any further expansion of state borrowing. This is not necessarily a bad thing; going on a diet (by reducing our debt dependency) must surely be healthy from a longer-term perspective.
In the immediate future, however, we may face another sharp downturn. In Keen’s words, “private sector deleveraging is still accelerating and has some time to go before it could be expected to slow. In the absence of net [new] government spending, it is highly likely that the downward spiral in output and employment would continue.”
Putting this another way, we may already have spent our Keynesian “New Deal” money, and those hoping for further fiscal stimulus are not facing the reality of governments’ balance sheets.
For the time being, equity investors are largely ignoring the continuing stresses in sovereign bond markets. However, if they were to reflect on the implications of what Keen is saying, they probably wouldn’t be so complacent.