Here’s issue #30 of my Policy and Politics Newsletter, written 5/15/12. The US government budget process and the elections in Europe have focused attention on how government can best spur economic recovery.
There are basically two schools of thought on how governments can spur economic recovery:
- Austerity: cut spending, raise taxes, and have tight monetary policy (i.e., high interest rates)
- Stimulate: increase or maintain spending, cut taxes, and have loose monetary policy (i.e., low interest rates)
The theory behind the austerity approach is that it will spur consumer and business confidence so they will increase spending and grow the economy. In addition, government spending and borrowing (i.e., deficits) take money out of the private economy. The theory behind the stimulate approach is that when consumers and the private sector are not spending enough to grow the economy, the government should step in and spend, even if it creates deficits in the short run.
In the short run, cuts in government spending eliminate jobs, either those of public sector workers or those of the workers who provide the goods or services purchased. Those goods and services may be purchased directly by governments (e.g., military equipment or construction of highways) or by the beneficiaries of government benefits (e.g., purchases by those receiving unemployment benefits or food stamps). In the US, the public sector, primarily state and local governments, are laying off about 10,000 workers a month because of reduced spending. This hurts efforts to reduce unemployment and the economic recovery.
On the other hand, government spending does create jobs; the best estimates are that the 2009 federal stimulus package created roughly 3 million jobs and kept the unemployment rate 2% lower than it would have been otherwise. (See newsletter #26, Economic Recovery: How and for Whom.)
In the US, the federal government initially took the stimulate approach, increasing spending and cutting taxes while moving interest rates to near zero to stimulate business and consumer borrowing. Now, the approach is shifting toward austerity with calls for reducing the federal deficit by cutting spending as evidenced by the budget deal last August and the budget recently passed by the House.
In the Eurozone and Great Britain, the austerity approach was adopted. The 17 Eurozone countries have slipped back into recession and Britain is tottering on the edge of recession, while the US has seen slow growth for eleven consecutive quarters. As Paul Krugman puts it, “the confidence fairy doesn’t exist – … claims that slashing government spending would somehow encourage consumers and businesses to spend more have been overwhelmingly refuted by the experience of the last two years.” 
Although everyone agrees that the US government must address its deficit, the question is when. Many economists and Federal Reserve officials believe that austerity now would hurt the US economy and that we should stimulate the economy first and tackle deficits after the economy strengthens.  Keep in mind that when the economy strengthens, more jobs, more production, and more sales will increase tax revenues and automatically begin to reduce the deficit.
The evidence seems pretty clear, both from current experience and the Great Depression, that in the short run austerity doesn’t work and that government spending spurs job creation and economic recovery. However, it appears that ideology is overwhelming the facts in both the US and Europe.