Robert Shiller summarizes the arguments for raising taxes and increasing government spending at Project Syndicate:
……while that [austerity] approach to debt works well for a single household in trouble, it does not work well for an entire economy, for the spending cuts only worsen the problem. This is the paradox of thrift: belt-tightening causes people to lose their jobs, because other people are not buying what they produce, so their debt burden rises rather than falls.
There is a way out of this trap, but only if we tilt the discussion about how to lower the debt/GDP ratio away from austerity – higher taxes and lower spending – toward debt-friendly stimulus: increasing taxes even more and raising government expenditure in the same proportion. That way, the debt/GDP ratio declines because the denominator (economic output) increases, not because the numerator (the total the government has borrowed) declines.
What he does not consider, however, is the message we are sending to government. In much the same way as bailouts increase moral hazard — with too-big-to-fail institutions taking on bigger risks secure in the knowledge that the taxpayer will bail them out if the bets don’t pay off — we encourage bad behavior from politicians if we allow them to raise taxes and increase government spending every time they screw up the economy. Federal government spending in the US economy has grown from 12.5% of GDP in 1950 to nearly 25% of GDP today. Seems like they are getting the wrong message.
That is like giving someone a promotion or a raise every time they mess up. When politicians fail, they need to get the right message — and not only at the next election. Cutting budgets when the economy is in recession is the right response, but how can we achieve this while saving the economy from a deflationary spiral?
The only way I can think of is to cut taxes and government expenditure, but encourage private investment in productive infrastructure through Treasury-backed low-interest or even interest-free development loans. These could be administered by an independently-elected infrastructure body with representatives from all parties. There are dangers, and the process would have to be closely monitored, but the risks are minor compared to rewarding failure.
Read more at Debt-Friendly Stimulus by Robert J. Shiller – Project Syndicate.