Since the financial crisis broke in 2008, there has been economic confusion as to what policies, if any, will help US and European economies recover.

Spending cuts, or ‘austerity’, have been strongly advocated;  by Republicans in the US, by Britain’s Conservatives, and by Germany. This school of thought believes that ‘confidence’ must be restored, for growth to resume.

Yet historical experience shows a different picture.

From the Great Depression and records of other financial crises, there is no example ever of a large economy – the US and Europe are the world’s largest – recovering as a result of austerity.

Depressed demand, in a recession or following financial crisis, results in decreased spending; and therefor reduced prices. Reduced prices mean reduced income, and threaten a ‘deflationary spiral’ as GDP slumps downward.

• Deflationary spiral:   income cuts & reduced cuts exacerbate a downturn,  resulting in further falls in income & spending.

Major economists such as Paul Krugman and recently, Joseph Stiglitz, have come out strongly in favour of continued Government spending; to maintain aggregate demand and avoid further downturn.

Demand must be maintained to near supply, to avoid (as occurred in the 1930′s) vast overcapacity — with steeply dropping prices, vast unemployment and catastrophic downturn taking 10 years or more for economies to recover.

These are the lessons of history. But until recently, Britain and Europe were trying to apply ‘austerity’ to their problem. However, this has led only to increased weakness in Britain’s economy, and greater danger of failure in Greece & Southern Europe.

With the political situation in flux following Greek & French elections, here’s hoping this provides a chance to reconsider direction.

Joseph Stiglitz:  After Austerity
Paul Krugman:  Europe’s Economic Suicide
Paul Krugman:  The Fatal Distraction

What do you think?  Add your comment.