Most policymakers have decided that we cannot add further stimulus to the economy due to worries over the government debt. In fact, many believe we need to start cutting the deficit now to head off growing financial market concerns over our long-run debt problem, a policy that comes at the expense of output and employment at a time when the economy is struggling to recover. The argument is that this will increase confidence, and the increased confidence will lead to economic recovery. But, as noted below by Paul Krugman, the evidence is not favorable to this argument.
The opposite story makes more sense to me. The deficit cutting measures being discussed by policymakers do almost nothing to solve the long-run debt problem (similarly, further stimulus adds almost nothing to it), but these measures will lower output and employment. When policymakers send a signal to financial markets that they think these measures are actually helping with the long-run debt problem (or being used as political cover so that politicians can avoid dealing with the long-run problem), or when they signal that they think further stimulus will add substantially to the long-run problem, when it won’t — when it will just make the economy worse — that undermines financial market confidence. That’s just the opposite of what you want to do during a recession.
The advocates of austerity want us to believe that deficit cutting measures that make the economy worse while having little impact on the long-run debt problem will somehow increase confidence and lead to recovery. It’s hard, though not impossible, to imagine how that will work. With enough imagination — the invisible bond vigilantes and confidence fairies discussed below — it’s possible to tell such a story. But there’s no reason to expect it has anything to do with the real world that we face right now. Furthermore, the answer to this is not to make the deficit cuts more severe in an attempt to make confidence go up rather than down — to actually take a big bite out of the long-run problem — as noted below there’s evidence that does even more harm to employment and growth:
Myths of Austerity, by Paul Krugman, Commentary, NY Times: …For the last few months, I and others have watched, with amazement and horror, the emergence of a consensus in policy circles in favor of immediate fiscal austerity. That is, somehow it has become conventional wisdom that now is the time to slash spending, despite the fact that the world’s major economies remain deeply depressed.
This conventional wisdom isn’t based on either evidence or careful analysis. Instead, it rests … on belief in what I’ve come to think of as the invisible bond vigilante and the confidence fairy.
Bond vigilantes are investors who pull the plug on governments they perceive as unable or unwilling to pay their debts. Now there’s no question that countries can suffer crises of confidence (see Greece, debt of). But what the advocates of austerity claim is that (a) the bond vigilantes are about to attack America, and (b) spending anything more on stimulus will set them off.