To Choose Austerity is to Bet it All on the Confidence Fairy

Joseph_stiglitz_140x140 Joseph Stiglitz in The Guardian:

The Keynesian policies in the aftermath of the Lehman brothers bankruptcy were a triumph of economic theory. In Europe, the US and Asia, the stimulus packages worked. Those countries that had the largest (relative to the size of their economy) and best-designed packages did best. China, for instance, maintained growth at a rate in excess of 8%, despite a massive decline in exports. In the US the stimulus was both too small and poorly designed – 40% of it went on household tax cuts, which were known not to provide much bang for the buck – and yet unemployment was reduced from what it otherwise would have been – over 12% – to 10%.

The stimulus was always thought of as a stopgap measure until the private sector could recover. In some countries, such as the US, politics rather than economics drove the size and design, with the result that they were too small and less effective than they might have been. Still, they worked. Now, financial markets – the same shortsighted markets that created the crisis – are focusing on soaring deficits and debts.

We should be clear. Most of the increase is not due to the stimulus but to the downturns and the bank bailouts. Those in the financial market are egging on politicians to ask whether we can afford another stimulus. I argue that Britain, and the world, cannot afford not to have another stimulus. We cannot afford austerity. In a better world, we might rightfully debate the size of the public sector. Even now there should be a debate about how government spends its money. But today cutbacks in spending will weaken Britain, and even worsen its long-term fiscal position relative to well-designed government spending.

There is a shortage of aggregate demand – the demand for goods and services that generates jobs. Cutbacks in government spending will mean lower output and higher unemployment, unless something else fills the gap. Monetary policy won't. Short-term interest rates can't go any lower, and quantitative easing is not likely to substantially reduce the long-term interest rates government pays – and is even less likely to lead to substantial increases either in consumption or investment.