The fight between Keynesians and free-marketers over the best way to handle the economy in a recession is decades old. Keynesians say that government spending will drive demand, thus stimulating the economy while also creating large deficits.
Alberto Alesina, an economics professor at Harvard, writes at the Wall Street Journal that the empirical evidence shows that cuts in government spending and tax rates are what boosts an economy (not Keynesian economics) by analyzing 200 fiscal adjustments in 21 countries over the last 40 years:
Politicians argue for increased stimulus spending, as opposed to spending cuts, on the grounds that it would speed up economic recovery. This argument might have it exactly backward. Indeed, history shows that cutting spending in order to reduce deficits may be the key to promoting economic recovery.
In Europe today, the risk of a renewed recession comes not from the spending cuts that some governments have enacted, but from a sovereign debt overhang and multiple bank failures. July’s stress tests were not reassuring because they didn’t test the exposure of European banks to sovereign debt; had they done so, many banks would have failed. Those banks remain a threat to the European economy.
In the U.S., meanwhile, recent stimulus packages have proven that the “multiplier”—the effect on GDP per one dollar of increased government spending—is small. Stimulus spending also means that tax increases are coming in the future; such increases will further threaten economic growth.