The Great Economic Experiment

Austerity as a Solution
The austerity approach currently followed in Europe rejects fiscal stimulus to the economy which increases an already large national debt, even during a recession. An increase in national debt during such a time is predicted to lead to higher interest rates, a loss of confidence in the economy, inflation and a depreciation in the external value of the currency. The reduction of such national indebtedness is a priority, even if it means higher taxes and reduced government outlays.
This formula, now applied across much of Europe, is challenged by some of the most distinguished economists in the profession. Professor Robert Skidelski, well know British economist and winner of several prizes in economics, labels European austerity as “utterly wrong”. Noble prize winner in economics, Joseph Stiglitz calls it a “suicide pact”, while Paul Krugman (also a Nobel prize winner in economics) labels it as “deeply destructive”.

Keynesian stimulus
Broadly speaking, the above mentioned economists favour a Keynesian approach which prescribes something quite different from the austerity followed in Europe. If an economy is in recession (a drop in demand) one of the first steps is usually to lower interest rates. The central banks of the major powers, including the European Central Bank, have reduced interest rates to below 1%.
Governments are advised in this situation (interest rates near zero) to make up the loss in private demand during a recession by increasing government spending, even if that means increasing the national debt. Reducing a large national debt is important but this should be addressed once the economy is growing again. To reduce national debt during a recession (though increased taxes or reduced government outlays) reduces demand still further and risks making the recession worse.
While Europe is pursuing the austerity prescription, the United States is more nearly (but not fully) pursuing the Keynesian path of government stimulus. Since the 2008 crisis, the Obama administration, with much opposition from the Republican party, has increased government debt by trillions of dollars, from 70% of national GDP in 2008 to 106% of GDP (Euro zone debt is at 90% of GDP). Obama plans to increase debt still further. US debt increases have been accompanied by the Federal Reserve’s policies of low interest rates, quantitative easing and credit creation.

Results
What are the results? Having followed the austerity path for several years , the Euro zone is entering its second recession, with five consecutive quarters of negative growth since 2011. It predicts continued negative growth at -.3% for 2013. Britain, which is quite separately following its own austerity programme, is on the brink of its third recession since 2008. The country has still to attain its 2008 level of GDP. According to the Financial Times, while the American GDP in 2012 was 2.4% above its 2008 pre crisis level, Britain was -3.3% below. Euro zone GDP was also below the 2008 level at -3%. Germany was the best of the Euro group at 1.4% above the pre crisis level with Italy at -7.6% below and Spain at -6.3% below.
Although the American recovery has been slow, its recession ended 18 months after the 2008 crisis. Since then GDP has been growing at an average of 2% annually. Not very satisfactory but much better than the growth rate in Europe. More significantly, key economic indicators in the USA have been moving in a favourable direction. Unemployment has reduced from 9.3% in 2009 to 7.9%, house prices (key to the onset of the crisis) have been improving rapidly as have housing starts. Automobile sales have risen to nearly pre-crisis levels. Manufacturing activity is improving. IMF forecasts 2013 GDP at 2%.
The trends in both UK and Euro zone are in the opposite direction, GDP is declining with unemployment in the Euro zone at 11.7% hitting new records. Automobile sales (a major indicator of overall economic activity) are greatly depressed.

The National Debt Disaster?
Has the increase in the American national debt by several trillions of dollars used to finance stimulus spending had the predicted dire effects? Not really. The predicted loss of confidence has not appeared as reflected in the lower interest rates (presently at 2%) that the American government pays lenders to purchase its sovereign debt.
Although the debt itself has increased from10 trillion dollars since 2008 to its present level of 16 trillion dollars, the actual cost of servicing the debt has remained stable, at 450 billion dollars, or 2.8% of GDP, due to the above mentioned lowering of interest rates. Inflation is within target limits registering 1.7% for December 2012 and averaging close to 2% since the crisis. The value of the dollar may be said to have declined somewhat but on the whole it has remained relatively stable.