Recently the economist published a chart comparing the evolution of domestic demand in OECD countries during three different, major recessions. The one caused by the oil crises and the fall of the Bretton Woods system reaching its peak in the third quarter of 1974. The recession affecting much of the developed countries in the late 70s and early 80s beginning with the energy crises and reaching its peak during the first quarter of 1980. And the global recession we are still facing right now having experienced its peak in the first quarter of 2008.
The graph states how many quarters it took domestic demand to return to its level at the height of the recession. It shows that the decrease in demand this time has been much more severe and lasted about four years until getting back to its former level. During the 70s and 80s this took only one year – one quarter of that time. This means that this recession has been – so far – much longer and according to the graph, also had more severe impacts on domestic demand than the ones before. The OECD states in its Economic Outlook, published at the end of november, that the causes for this are uncertainty, fiscal consolidation and the ongoing euro crisis.
This is somewhat puzzling as the expected evolution of domestic demand should look differently according to economists such as Alesina, Mankiw and Barro. They argue that fiscal consolidation should improve trust of consumers and lead to a positive or at least less severe (in comparison with tax raises) effect on economic growth. The European Commission followed this argument and supports spending cuts in troublesome economies such as Greece, Portugal and Spain.
In comparison to this, economists such as Krugman and Blanchard support the Keynesian view that the government should not cut spendings during recessions as this will harm the economy even more and lead to an even more dramatic development. A recent study by Blanchard and Leigh supports this, stating that the fiscal multiplier – an indicator how national income is affected by a change in government spending – has been underestimated by large. They say that a decrease in government spending will have severe consequences on economic growth – and thus on domestic demand.
The graph above seems to support this view. The decrease in domestic demand has been much more dramatic than in previous recessions and lasted for much longer. Fiscal consolidation does not seem to have had a positive impact on demand, as expected, but instead a very negative one. Just focusing on this graph it seems that the Keynesian view does not seem to be that far away from reality in the end. During the recession in the 1980s decision-makers chose to increase deficit spending (i.e. the extension of spending through an increase in deficit) and lower interest rates. They ended up with a very fast return to the former demand level and growth on the long run. Even if we would take into account that causes and structures of recessions have been different and cannot be compared, the warnings that the current economic policy might have drastic consequences become more and more evident.
Written by Julia Seither