Yanis Varoufakis explains in the short video below why austerity doesn’t work. He uses the example of the UK economy, and leaves out the foreign sector (trade and investment), which does simplify things. I would argue that including the latter in the model is in fact vitally important to our understanding in the case of economies open to foreign trade and investment.
One reason for this is because a deflation which results from government austerity reduces the demand for imports from abroad, which negatively affects trading partners. Devaluing the currency can also have this effect, and is potentially an example of a ‘beggar-thy-neighbour‘ policy. The devaluing country may only gain at the expense of others, which can invite retaliation. This can take the form of competitive devaluation: if one country devalues, its growth might increase for some time, but if all countries do the same, the global benefits may be zero, while their distribution will tend to be uneven.
A small country open to international trade can adopt a deflationary fiscal policy and devalue its currency, in order to rebalance its economy away from domestic demand and improve its export competitiveness. This has often been the policy imposed by the IMF on developing countries in crisis as a condition of lending. But if all countries deflate and devalue, the result will be a global recession.
This illustrates the importance in macroeconomics of analysing the world economy as a whole system, whose interacting parts can produce effects not obvious when looking at a single economy. This is an insight found repeatedly in the work of Michael Pettis, whose book The Great Rebalancing offers an original explanation for the Great Recession of 2008 and the likely global economic outcomes in the years ahead.