Here is an interesting post by J. Bradford DeLong on the current push toward austerity in light of the current soft economy. He first makes the point that there is no "bedrock set of economic principles" like in Biology or Chemistry. One type of economist relies on theory and an answer can be determined by the assumptions the theorist applies until the 'right' conclusion is reached. He then notes that there is a second type of economist who relies more on history. He places Mill in the latter type. DeLong notes Mills conclusion that excess demand for financial assets corresponds to excess supply for goods and services as well as an excess supply of labor. This is certainly the case today. DeLong notes that if the demand is for long term assets, the Mills solution is for the government to borrow more (fiscal policy) or guarantee private assets (banking policy).
Given the historic low yields on bonds such as the US treasury 10-yr note, Delong may have a good point here. If we focus too much on the 'theoretical' implications of the growth in government debt, governments could pursue the wrong policy, extending the current economic softness.
Of course the next question is what about Greece and the other European counties facing default? The EU has a long term problem from moving to the Euro and in the end the long run feasibility of the Euro is questionable. But a 'banking policy' for Greece etc. may be the best solution in the short run as the weak countries get their fiscal house in order. Then a higher tax policy like the 1990s in the US would move things back to a better fiscal balance. For those who argue that higher taxes will slow the economy should remember that in the 1990s, higher tax revenue (along with constrained spending) reassured investors that debt would not be monetized and inflationary expectations would be held in check, keeping interest rates from rising offsetting the negative effects of taxes.
History may be the best guide for policymakers after all.
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