Austerity versus Stimulus: The Post-2008 Debate

The austerity programs implemented in the United States and, more severely, in Europe after 2010 represent the most significant macroeconomic policy failure of the post-World War II era -- a failure that was thoroughly documented in real time by economists who had predicted it, ignored by the policymakers who implemented it, and whose consequences are still being felt in the political upheavals of the decade that followed.

The intellectual foundation for post-2008 austerity rested on two empirical claims that subsequently collapsed. The first was Carmen Reinhart and Kenneth Rogoff's (2010) finding that countries with public debt above 90% of GDP experienced significantly lower economic growth. This finding, which became a central reference point for austerity advocates across the political spectrum, was invalidated when researchers discovered a spreadsheet error in the original analysis: when corrected, the growth differential at high debt levels was far smaller and not statistically significant. The threshold that justified austerity was a computational artifact. The second claim was the 'expansionary austerity' thesis -- that fiscal consolidation could be growth-enhancing by improving confidence and reducing risk premiums. The IMF's subsequent analysis of actual consolidation episodes found that austerity typically reduced output and employment, particularly when implemented at the zero lower bound (Herndon, Ash and Pollin, 2013; Guajardo, Leigh and Pescatori, 2011).

In the United States, the American Recovery and Reinvestment Act of 2009 was followed not by continued stimulus but by the austerity turn of 2010-2015. The Budget Control Act of 2011 and its successor, the sequester of 2013, removed fiscal support from an economy still operating well below potential. The CBO estimated the sequester reduced GDP growth by about 0.6 percentage points and employment by approximately 750,000 jobs in 2013. Federal investment -- in infrastructure, research, education, and human capital -- fell to its lowest share of GDP since the 1950s. The recovery that followed was the longest on record in absolute duration but also the slowest in terms of per-capita income growth, with millions of workers cycling through long-term unemployment or labor force exit rather than returning to productive employment (Congressional Budget Office, 2013).

We implemented austerity when the economy needed stimulus, at a moment when the government could borrow at real interest rates near zero, when there were millions of unemployed workers and idle productive capacity, and when every economic model predicted that deficit spending would increase output and employment. The austerity was a choice, not a necessity -- and a catastrophically wrong one.Adapted from Paul Krugman, End This Depression Now! (2012)

The distributional consequences of post-2008 austerity compounded its macroeconomic costs. Government employment fell, disproportionately affecting public sector workers who were overwhelmingly in the bottom half of the income distribution. Infrastructure investment reductions imposed costs on communities rather than on financial sector employees whose reckless risk-taking had caused the crisis requiring austerity. Healthcare and housing assistance cuts hit the most economically vulnerable. Meanwhile, the Federal Reserve's unconventional monetary policies -- which partly offset the austerity's macroeconomic damage -- inflated asset prices, primarily benefiting those who already held the most assets. The combination produced an outcome in which the costs of both the crisis and the policy response to it fell disproportionately on those least responsible for the crisis.

The contrast with the post-COVID response could not be starker. Five trillion dollars in fiscal support produced a recovery that restored employment to pre-pandemic levels in less than two years -- compared with the six years it took after the 2008 crisis. The lesson is not that deficits never matter but that their consequences depend critically on the economic context: deficits that finance productive spending when the economy is below potential and interest rates are low are expansionary; deficits that finance consumption when the economy is at full capacity can be inflationary. The post-2010 austerity imposed deflationary discipline at precisely the wrong moment, and the post-2020 stimulus demonstrated what adequate fiscal support can accomplish.