The place to begin is 2009. By then the full extent of the financial crisis had become apparent. Although the crisis originated in the US, it had spread around the world, leaving no country unscathed. The major UK banks had to be bailed out, not so much as a result of excessive lending to UK borrowers, but because of their unwise overseas investments. The main weapon used to fight recessions is interest rate cuts – lower interest rates encourage consumers to spend rather than save, and business to invest – and by 2009 interest rates had been reduced to nearly zero in all the advanced countries. Yet output continued to decline.The last part is very significant. Although Obama's foolish pursuit of bipartisanship and Republican obstructionism prevented the stimulus in 2009 being large enough to push the US economy back into healthy recovery as quickly as it could have, as Paul Krugman has explained repeatedly, it was large enough to make the US recovery notably more robust than that of the eurozone. But it's also important to note that Angela Merkel's government was more willing to apply at least limited stimulus in Germany, though they have insisted on brutal austerity in the southern eurozone, especially in Greece.
The response of governments and central banks was twofold. First, the Bank of England and the US Federal Reserve embarked on a programme of ‘quantitative easing’, which involves the temporary creation of money, thereby making it possible for central banks to buy long-term financial assets. Second, governments started to spend more or cut taxes, which economists call a fiscal stimulus. The last Labour government’s measures included a cut in VAT in late 2008, albeit for just a year. Barack Obama managed to enact a package of measures which included higher government spending as well as lower taxes, and even Germany undertook a fiscal stimulus package in 2009. The normally austere IMF agreed that fiscal stimulus was the way to go in 2009. [my emphasis]
Wren-Lewis then goes into an accessible discussion of the basic macroeconomics of the need for counter-cyclical fiscal policy in a recession or depression. And he includes this description of how opponents of stimulus can use fear of deficit spending to prevent such a fiscal policy:
A sharp increase in government borrowing sounds bad. Opponents of fiscal stimulus like to invoke comparisons between individuals and governments. Most individuals are rightly cautious about borrowing, although many do so – for example, to buy a house. A firm may borrow to help fund an investment project. Government borrowing in a recession is neither buying an asset nor funding investment, so isn’t it common sense that it should be brought to an end as soon as possible? The view of nearly all economists is that the analogy between individual and government borrowing breaks down at this point. The name they give the process by which deficits rise in a recession – the ‘automatic stabiliser’ – itself explains why they think this way. If a recession is caused by consumers saving more and spending less, which in 2009 it was, then the fact that consumers are paying less in taxes and the unemployed are getting welfare benefits is a good thing, because it supports consumer incomes. If governments turn off the automatic stabilisers by cutting spending or raising taxes, they will reduce the income of consumers, who will spend even less, making the recession worse. Just as a fiscal stimulus helps in a recession, a fiscal contraction designed to reduce the deficit will make the recession worse.He reminds us of how the term Confidence Fairy entered the economics vocabulary:
What about the problem that austerity would make the recession worse? Supporters of austerity put forward two counter-arguments. First, the prospect of a rising government deficit would worry consumers and firms so much that they would spend less as a result; if the government reduced the deficit, the confidence of the private sector would be restored, and it would start spending more. In other words fiscal austerity – cutting government spending or raising taxes – would help stimulate the economy. This flips conventional macroeconomic logic on its head; Paul Krugman dismissed it as believing in the ‘confidence fairy’.He also talks about how the supposed effectiveness of monetary policy failed in the depression conditions of interest rates being at what economists call the "zero lower bound."
This is one area one which New Keynesians like Krugman differ from more orthodox Keynesians and "post-Keynesians" including the Modern Monentary Theory adherents. The New Keynesians have considerable faith in the effectiveness of monetary policy in normal times and in smaller recessions, leaning even toward a preference for monetary over fiscal policy. The others are far more skeptical of the effectiveness of monetary policy. The late John Kenneth Galbraith used to say something to the effect that he would have loved to do away with the belief that monetary policy was any use at all.
Wren-Lewis also explains some of why the debt situation of individual countries within the eurozone was different than that of countries like Britain who borrow in their own currency.
He also uses a very servicable term, "miediamacro":
‘Mediamacro’ is the term I use to describe macroeconomics as it is portrayed in the majority of the media. Mediamacro has a number of general features. It puts much more emphasis than conventional macroeconomics does on the financial markets, and on the views of participants in those markets. It prefers simple stories to more complex analysis. As part of this, it is fond of analogies between governments and individuals, even when those analogies are generally seen to be false by macroeconomists. So after the 2010 election (and to some extent before it) mediamacro had bought with barely a murmur the view that reducing the government deficit was the top priority. It even bought a second story, which was that the previous Labour government had played a large part in creating the deficit problem in the first place. Like all good myths this was based on a half-truth: before the recession Gordon Brown had been a little less prudent than he should have been: he had been too optimistic about tax receipts, and followed a fiscal rule that allowed his progress in reducing debt in the early years of the Labour government to be reversed in later years. But as the chart shows, the impact of this on the deficit was dwarfed by the influence of the recession, and the recession was the result of a global financial crisis. Despite this, mediamacro allowed the myth of Labour profligacy to go unchallenged.And even with a more left-leaning Labour Party under the current leadership, deficit fetischism is still very evident in British politics:
In many senses this echoes Labour’s original line that the coalition’s austerity policy was too far, too fast. Yet such is the influence of mediamacro’s alternative view that the Labour Party has abandoned that stance, and now wants to portray itself as being just as tough on the deficit as the coalition. This has led to a ludicrous situation as the election approaches. Respected economists and think tanks agree that there is a large gap between Labour and Tory plans on future austerity. Even under the most conservative interpretation, Labour’s plans involve fewer spending cuts, amounting to 1.5 per cent of GDP per year less than the Tories are proposing. That’s equivalent to half the UK defence budget, every year. Yet the Labour Party itself seems reluctant to acknowledge this fact, because it doesn’t want to appear weak on the deficit.But: "Mediamacro still sees reducing debt as the number one priority." [groan!]