The problem is private sector debt

The current focus of commentators, economists and politicians on public sector deficits and debt is completely inappropriate. In fact it shows that they do not really understand the global financial crisis, and have not absorbed the clear lesson from the Great Depression.

The figure shown below is from Steve Keen's excellent Debtwatch website. If one looks at private sector (individuals, households and businesses) and public sector (government, state and cities) debt over the past century it is fairly obvious that the Great Depression and the Global Financial Crisis were immediately preceded by exceptionally high levels of private debt.
This is no coincidence. In both cases excessive credit creation by banks, supported by the resulting increases in asset prices (stocks and property) were directly responsible for the increase in private debt. Banks became highly leveraged as a result. When the asset price bubbles popped and prices dropped many banks, with thin capital cushions, became insolvent, precipitating banking crises. Banking crises and the accompanying credit contraction resulted in contractions in economic activity. This resulted in falls in tax revenues and increases in government spending on unemployment benefits and bank bailouts. As a result public sector debt levels rise, while private sector debt begins to fall.

Now it is a simple, but much ignored, accounting reality that the aggregated private sector can only reduce its debts if the public sector runs a deficit and increases its debts. The decrease in private sector debt following the Great Depression was thus accompanied by increases in Public Sector debt. Similarly the decrease in private debt we are now seeing has been accompanied by an increase in government debt. This is both normal and necessary. To argue for cuts in budget deficits makes no sense when the private sector is overburdened with debt and needs to deleverage.

Those arguing for cuts now on the basis that 'you can't solve a debt problem with more debt' have also forgotten that following the Great Depression exactly the same mistaken arguments lead governments to impose austerity then, with predictably disastrous results. Growth collapsed again and unemployment remained stubbornly high. It was only when deficit spending was renewed with vigour that recovery began. This became politically possible because the Second World War marginalised the deficit hawks. As one would expect deficit spending enabled the private sector to fully deleverage by the end of the war. Growth was restored and public sector debts dropped gradually as a proportion of GDP.

Unfortunately the lesson of the Great Depression were forgotten, and we returned to policies which encourage growth in private sector debt. Mainstream economists did not consider mounting private sector debts as a cause for concern, and they still don't acknowledge that this was a problem! Instead they focus their efforts on trying to get bank lending (and thus private sector debt) to return to its pre-crisis upward trajectory by running very loose monetary policies, lowering the cost of borrowing to their lowest levels in history. At the same time they voice loud concerns about government deficits and debt. 

I have argued in previous posts that this is seriously mistaken. To rely on bank credit creation to provide the monetary expansion needed to fund growth in demand is to require that the private sector to become increasingly indebted. Not only is all newly-created money matched by debt. The requirement to pay interest on the debt ensures that more borrowing is needed just to meet these payments. To prevent the private sector become over-indebted I have argued there should always be deficit spending. Deficit spending  is when governments spend more money into the economy than they extracted through taxes. This injects debt-free money into the economy, enabling the aggregate private sector to avoid excessive accumulation of debt.