The Great Recession began in the US in December 2007.  We are coming up on five years since things began to go slump in the night.

And yet…   Where are the signs of recovery?  So far, except for a few bright spots in the U.S. in housing and autos, they remain absent.  Overall, U.S. economic growth remains very weak — annual GDP growth was 1.7% in the latest quarter (Q2).  And that is the strongest performance among the rich economies.

More significantly, growth expectations are still being revised downwards.  China’s growth rate continues to fall, from 10% in 2010 to 9.1% in 2011 to the current World Bank estimate of 7.7% for 2012; which may still be optimistic given the lower rates in the 2nd quarter.  India and Brazil are growing at only a fraction of their rates two years ago.  The UK — supposedly one of the strongest economies in Europe — has had its growth forecast  for 2013 revised down by the IMF from a positive 0.2 percent to a negative 0.4%.  Indeed, the IMF has reduced its growth forecasts all across the globe, arguing that this has been necessary because austerity policies have had much more negative impacts on growth than expected.

The IMF and other agencies are now seeing, as we have argued for years, that because of demographic change, the long-term growth potential of rich countries (and China!) has been permanently reduced by up to one percentage point per year.

While that may not seem huge, we are talking about shifts in rich countries growth potential from around 3.2 percent to around 2.2 percent per year — or almost one-third of recent ‘normal’ growth.  In the U.S., the difference amounts to about $1.5 trillion per year, money that would be available to pay down the deficit or invest for future growth.  If that money is gone, it means a tough contest in the future for available funds between debt reduction and investment for the future — a contest that is defining politics around the world as well.

It is astonishing but we are seeing a world repeating the mistakes of the 1930s – not in regard to monetary policy, where central banks are doing all they can to maintain liquidity — but in fiscal policy, i.e. taxing and spending.

In the early 2000s, rich countries and their consumers ran up huge debts to maintain and expand spending, in part because the financialization of economies made expanding debt an ever-larger part of the means to fuel economic growth.  When the party stopped in 2007, rich countries and their banks were already holding huge loads of government debt, which only increased with the recession’s loss of employment and revenues.  In a few countries, such as Ireland and Greece, the debts were so large that banks and governments could not even keep up with interest payments, forcing partial defaults.  In other countries, debts are so large that keeping up with interest payments has been possible, but only at the price of rising interest rates, doubts about their future credit, and imposing sharp increases in taxes and reductions in other government spending.

Behind this approach lay three beliefs characteristic of the 1930s:  (1) Debt reduction without inflation or default is the most important factor for the future health of economies; and (2) When government cuts back on spending, that leaves more liquidity in the economy for the private sector, which will then spend more and provide growth; and (3) ‘normal’ growth will soon return and when it does, if government spending has been reduced, the debt will quickly fall to easily manageable levels restoring credit for future investment.

Unfortunately, when a country is in a financial-leverage induced growth crisis, none of these conditions hold any longer.  First look at condition number 2.  As Rogoff and Reinhart have amply demonstrated, during a financial-leverage recovery, consumers and business want to pay down their debts rather than borrow.  That means a liquidity trap, in which no matter how much you lower interest rates or make liquidity available, that has little or no impetus to increase borrowing and spending.  That means the mechanism of austerity (cutting government spending to make more liquidity available elsewhere) actually works in reverse.  Instead of reduced government spending producing growth elsewhere, the reductions in government employment and spending make it harder for people to make enough to reach their savings targets, and so they try even harder to cut spending.  The IMF now says that the multiplier which says how much we can expect output to fall when governments cut spending, which is normally around 0.5 (for every $1 of government spending cuts, the overall economy loses 50 cents of output as private sector growth makes up half the loss), has in recent years been more like 0.9 to 1.7.  That is, cuts in government spending cause the economy to contract by as much or more than the government cuts spending.  That means austerity is just pushing countries into a tailspin of ever lower output.

Now look at the third condition.  Because of demographic change (the aging and retirement of the baby boomers, which will dominate the economy of rich countries from 2011 to 2030) the ‘new normal’ rate of growth is slower.  We cannot expect to return to 3% growth.  So austerity not only depresses output — it is going to depress it from already reduced levels.  The result is that the ability of the economy to grow fast enough to reduce the level of government debt is essentially gone — unless the real value of the debt is reduced by inflation.  That is, if we are looking at real growth of 2.2 per year, and have huge debts to pay off, we absolutely cannot pay off that debt simply by saving out of real growth.  There is just not enough growth to pay off the debts, invest in future growth, and allow anything for increases in consumption or health care or other desired spending.

The best course would be to allow countries in severe trouble to write down some of their debts (like any business), and encourage others to seek higher nominal growth through inflation.  If nominal growth is 5.2%, even if real growth is only 2.2%, then the real value of past debts declines by 3% per year and becomes manageable (yes, interest rates for new borrowing may be higher, but it is the burden of past debts that is halting spending and forcing people to save to deleverage).  They of course should also do everything possible to increase real growth by investment in education, infrastructure, reduced taxes, and government support for research and new technologies.

So this means the first belief — that paying down debts without inflation or default is the most important task to restore  growth — is simply wrong.  Indeed this course is both ineffective and harmful in current economic conditions.

Unfortunately, politics trumps economics, and for historical reasons, current political leaders feel that intentionally allowing 3% inflation, or prioritizing government investment for the future over cuts in current spending, are poison.  Sadly, they are not poison but just the nutrition that world economies need.  Failure to see that means we are repeating the mistakes, and the suffering, of the 1930s for the foreseeable future.