Reducing aggregate demand when spending is already falling makes things worse, not better:
Pain Without Gain, by Paul Krugman, Commentary, NY Times: Last week the European Commission confirmed what everyone suspected: the economies it surveys are shrinking... It’s not an official recession yet, but the only real question is how deep the downturn will be.
And this downturn is hitting nations that have never recovered from the last recession. ... Worse yet, European leaders — and quite a few influential players here — are still wedded to the economic doctrine responsible for this disaster. ...
Specifically, in early 2010 austerity economics ... became all the rage in European capitals. The doctrine asserted that the direct negative effects of spending cuts on employment would be offset by changes in “confidence,” that savage spending cuts would lead to a surge in consumer and business spending, while nations failing to make such cuts would see capital flight and soaring interest rates. ...
Now the results are in... The confidence fairy has failed to show up: none of the countries slashing spending have seen the predicted private-sector surge. Instead, the depressing effects of fiscal austerity have been reinforced by falling private spending.
Furthermore,... austerity’s star pupils, countries that, like Portugal and Ireland,... still face sky-high borrowing costs. Why? Because spending cuts have deeply depressed their economies, undermining their tax bases to such an extent that the ratio of debt to GDP ... is getting worse rather than better.
Meanwhile, countries that didn’t jump on the austerity train — most notably, Japan and the United States — continue to have very low borrowing costs, defying the dire predictions of fiscal hawks. ... Yet as far as I can tell, austerity is still considered responsible and necessary despite its catastrophic failure in practice.
The point is that we could actually do a lot to help our economies simply by reversing the destructive austerity of the last two years. That’s true even in America, which has avoided full-fledged austerity at the federal level but has seen big spending and employment cuts at the state and local level...: all the federal government needs to do to give the economy a big boost is provide aid to lower-level governments, allowing these governments to rehire the hundreds of thousands of schoolteachers they have laid off and restart the building and maintenance projects they have canceled.
Look, I understand why influential people are reluctant to admit that policy ideas they thought reflected deep wisdom actually amounted to utter, destructive folly. But it’s time to put delusional beliefs about the virtues of austerity in a depressed economy behind us.