Despite the evidence to the contrary, the dominant sentiment among politicians, academics and journalists in the United States, Europe and Japan continues to be that stimulating the economy via fiscal and monetary policy is the answer to the economic stagnation.
It was stimulation—coupled with lower tax revenue due to the recession—that got several European countries into much more trouble than they already had after 2008. Originally they had a credit problem but then turned it into a fiscal and sovereign debt problem through stimulation—Spain being a perfect case in point. Others, such as the U.S., already had a fiscal and sovereign debt problem but made it much worse through stimulation (although it has been able to temporarily conceal the effect because the Federal Reserve can print money like crazy and the U.S. dollar is still an international reserve currency.)
In almost every country, the response to the crisis brought about by the bursting of the credit bubble in 2008 was fiscal and monetary stimulus. Four years later, the results are very clear: there has been scant economic recovery and the existing issues have been compounded by new ones, or exacerbated to higher degrees.
Arthur Laffer recently came up with a useful comparative analysis about the effects that fiscal stimulus has had on the economies of various countries these past few years. The four countries where the stimulus was proportionally greatest–Estonia, Ireland, Slovakia, and Finland–are also the ones where the rate of economic growth turned most negative. Spain is among the seven countries that increased fiscal spending the most as a percentage of the total size of their economies between 2007 and 2009 . . . and is therefore also among the nine countries where the economy subsequently contracted the worst. The United States, where spending increased by more than 7 percent, suffered one of the most severe setbacks later on.
This illustrates the point I was making earlier. In 2007 Spain had a fiscal surplus and government debt did not represent more than one third of the size of the economy–a small proportion by today´s astronomic standards set by indebted country after indebted country. Now the situation is so bad that Europe is engulfed in a fierce political debate over whether the European Central Bank should, in violation of its rules, rescue the economy by funding the Spanish government on a massive scale, and whether what was originally supposed to be a 100-billion-euro bank rescue should turn into a full-fledged country rescue by the International Monetary Fund and the European Union.
A not-too-different debate is going on in the United States about whether the Federal Reserve should engage in a new round of quantitative easing–QE3. Through previous interventions (QE1 and QE2), the Fed has already accumulated trillions of assets—which is the way in which it pumps money into the system. What has been the effect of this stimulus? Essentially, the lowering of interest rates to ridiculous levels and the growth of excess bank reserves
None of this is rocket science. Fiscal stimulus does not work because it involves taking money from some people and handing it to other people. It does´t create any new wealth–all it does is transfer existing wealth and kill the incentive to create more on the part of those who have it taken away from them (or expect to have it taken away in the future through the taxes that will inevitably be raised in view of the deficit.) In the case of monetary stimulus, what happens is no less commonsensical: if families and businesses are not yet ready to borrow a lot of money again, and banks are not ready to dish it out just yet, no matter how much money is pumped in it will not end up where it is intended. Instead, it will accumulate at the Fed or will be channeled into speculation, inflating future bubbles.