The cause of current anemic GDP growth is evident from the recently-released Z1 Flow of Funds report. GDP recovery from 2008/2009 is accompanied by only a modest rise in Domestic (Non-Financial) Debt — which is now constraining further growth.
Domestic (Non-Financial) Debt is made up of Government Debt and Private (Non-Financial) Debt — which can be further broken down into Household and Corporate debt. The Financial sector is excluded as it mainly acts as a conduit, channeling debt to other sectors of the economy. We can see below that Private (Non-Financial) Debt contraction was far greater than overall Domestic (Non-Financial) Debt. What saved the economy was a sharp spike in Government Debt in 2009, offsetting the fall. The massive fiscal deficit may have left a public debt hangover, but failure to offset the contraction in private borrowing would have had more serious consequences: a GDP collapse similar to the 1930s.
Resumption of corporate borrowing has dragged Private (Non-Financial) Debt growth into positive territory but growth remains anemic and households continue to de-leverage. Cessation of government borrowing would cause a fall in overall Domestic (Non-Financial) Debt growth to near zero and a sharp fall in GDP. The economy needs to be gradually weaned off stimulus spending in order to minimize disruption to growth. And not before Private sector borrowing recovers. We need a clear deficit-reduction plan, over 5 to 10 years, in order to restore corporate sector confidence and encourage new capital investment.
The only alternative is further quantitative easing (QE3), where continuous deficits are funded by borrowing from the Fed. But that poses a whole new set of problems — and could lead us back to square #1.
