Take a look at this chart posted by Professor Krugman, which shows how government spending has changed over the past decade. Notice particularly what happened to government spending after the recession of 2008-09 officially ended (recessions are the periods shaded in gray). You can see that consumption of goods and services by all levels of government has plummeted dramatically during the past year and a half.
Keep this in mind when considering the July jobs data, released yesterday. On a net basis no jobs were created last month. Private hiring climbed an anemic 17,000 in July, but this was more than offset by a decline in government employment, which slumped 20,000. Krugman argues that we are beginning to see the impact on the job market of the fiscal austerity policies, as all levels of government cut spending as quickly as they can. Whether your politics tells you that shrinking the government is a good thing or a bad thing, it is undeniable both that government employs millions of people and that government consumption of goods and services supplied by the private sector is a huge component of aggregate demand. Cuts in government spending therefore reduce demand for goods and services unless the private sector picks up the slack. While in normal times, the private sector can often do that, these are not normal times. We are in a liquidity trap. Absent dramatic policy changes that do not seem to be in the offing, private sector demand will be hamstrung for years as consumers continue to pay off accumulated debts.
(A good, terse analysis of many of last month’s most important economic statistics, including the labor market report, can be found at Bill McBride’s award-winning website here.)