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The big debates

Austerity vs stimulus

Learn why economists split over cutting deficits or spending after 2008, and where the argument stands today

Specification: AQA 4.2.5.1 Edexcel 2.6.2

Take a guess

Before you read on: IMF economists later checked growth forecasts made in 2010 for Europe. How did countries planning the biggest budget cuts do?

The debate at a glance
The two sides
Austerity: cut deficits through spending cuts and tax rises. Stimulus: keep spending up, borrowing if needed, until recovery is under way, as Keynes argued in the 1930s
When
From 2010, after the Great Recession of 2007 to 2009; revived after Covid-19
The question
After a deep slump, should governments cut their deficits or spend to support recovery?
Key episodes
The US Recovery Act (2009); the rescue of Greece (May 2010); Britain's June 2010 Budget
Key research
Alesina and Ardagna (2009); Reinhart and Rogoff, Growth in a Time of Debt (2010); Eggertsson and Krugman (2012); Blanchard and Leigh (2013)

What the argument was about

The financial crisis pushed rich countries into deep recession, and deficits grew. In 2009 the United States passed the American Recovery and Reinvestment Act, a stimulus first costed at $787 billion.

In 2010 Greece needed rescue loans from the euro area and the IMF, and several European governments, including Britain's new coalition, began to cut deficits. Would cuts restore confidence or deepen the slump?

The two cases

Austerity

The case

High public debt carries risk. If lenders doubt a government can repay, they charge more to lend. Jean-Claude Trichet, president of the European Central Bank, argued in 2010 that credible deficit cuts would lift confidence and so support growth. Alberto Alesina and Silvia Ardagna found that, in rich countries from 1970 to 2007, spending cuts were more likely than tax rises to bring debt down, and less likely to cause recessions.

The evidence it points to

Britain's June 2010 Budget argued that faster cuts would keep market interest rates low, pointing to rising borrowing costs in Spain, Portugal and Ireland. Carmen Reinhart and Kenneth Rogoff found that growth was weaker when public debt was above 90% of GDP (a country's total output). IMF economists found that lower debt tends to raise output in the long run. Olivier Blanchard and Daniel Leigh, whose forecast study the stimulus side cites, found the link weakened after the crisis's first years, and wrote that their results did not mean cutting deficits was undesirable.

Stimulus

The case

In a deep slump, households and firms are already cutting back. If the government cuts too, spending falls further and more people lose jobs. A central bank would normally offset this with lower interest rates, which it cannot do at the zero lower bound, the floor near zero for interest rates. Paul Krugman and Gauti Eggertsson argued that in this trap, extra government spending raises output by more than the amount spent.

The evidence it points to

Blanchard and Leigh found that 2010 forecasts implicitly assumed a multiplier (output lost per £1 of budget cuts) of about 0.5, while their estimates put it above 1 early in the crisis. Laurence Ball, Leigh and Prakash Loungani found, across 173 episodes, that cutting the deficit by 1% of GDP lowered output by about 0.6% within two years. In 2013 Thomas Herndon, Michael Ash and Robert Pollin reported a spreadsheet error and questioned how Reinhart and Rogoff had weighted and excluded data. Corrected, average growth above 90% was about 2.2%, where the original showed slightly below zero. Reinhart and Rogoff accepted the spreadsheet error, rejected the other charges, and said high debt still went with slower growth.

Ideas from the debate

Can you name the four ideas, two from each side, at the heart of the debate?