I tried to keep it short and focused. I really tried!
Spending Too Much
First we need to differentiate between the government and the society. This is an extremely important difference. To say that country X spends too much can mean two completely different things.
(a) On the one hand, it can mean that its government spends more than it takes in in taxes.
(b) On the other hand, it can mean that the country, the entire society, imports more goods than it exports, which necessarily is either financed with debt, by printing money or by sending people in other countries to work there and send the money back home.
Having people work in other countries is sub-optimal for their families but it's sustainable. Printing money can be sustainable but leads to several problems which originally encouraged Southern-European countries to want to help create and then join the Euro. What is not sustainable is to finance the imports with external debt for forever.
However, this post is about point (a): Governments which spend more than they take in with taxes.
A government spends money to meet its obligations. But to be able to spend the money it first has to get it. There are basically three ways to do this.
(a) Printing money
Printing used to be a very common source of government revenue in the past and it's still important nowadays. In the very long-term printing money causes inflation. Inflation means that all goods and services become more expensive. As people then can buy less with the money they have, inflation causes a subtle inflation tax.
But inflation is never a smooth process. The money first flows to e.g. a bank and then may even stick to specific markets and cause bubbles. But in the very, very long term, if there's suddenly twice the amount of money in the economy, but the same goods and services are traded with its help, all prices double.
Keep in mind that the very, very long-term is often irrelevant for reality. Prominently, J. M. Keynes said “In the long run we are all dead”. This isn't so much a statement about your children as an attempt to make clear that the long-term is often rather unimportant when there are things happening in the short-term all the time. Or, in other words, if you printed money and then waited for 100 years without anything else of significance happening, the long run were important. But if important things happen all the time, the constant short-term consequences matter at least as much as the long-term consequences, if not more.
There isn't really a limit to printing money. And since politicians in democracies need to appeal to voters to be elected, printing money is considered a very bad practice. The ECB is as independent as possible from politicians for this reason. The FED is not that independent but it knows the consequences of unlimited printing to pay for government programs (I hope).
For these reasons, let's ignore printing money as a source of government revenue. More important for modern government financing are debt and taxes.
We need to differentiate between internal and external debt. Japan would be an example for internal debt. This means that the Japanese citizen gave loans to their government. Argentina or Russia are examples for (mostly) external debt. The rest of the world gave loans to these governments. The distinction is very important.
You might have noticed that Japan has a much higher debt/gdp ratio than almost any country on earth. That's possible because nobody expects them to default on their debt. And the reason is that it wouldn't benefit Japan. In fact, since rich individuals, and organizations controlled by rich individuals, are the main owner of government debt papers, and exactly these individuals, in all societies, have a major impact on the decisions of the government, it's considered improbable that Japan defaults anytime soon.
This is quite the contrast to Argentina, Russia, and even Greece where the debt was and is to a large extend external. The government would gain a lot by defaulting - which is why investors stop lending money much sooner to Greece than to Japan. Of course, ever increasing internal debt is not sustainable for Japan, either. But the debt/gdp ratio, at which investors are unwilling to finance the government any more, is much, much higher than in Argentina, Russia, Greece .. and maybe the US.
Internal debt means that a government asks its own people to give them money now, in exchange for the promise to pay the money plus an interest back in the future. If a country defaults on its internal debt, it redistributes immense amounts of wealth from the creditor citizen to the government (which is “owned” by the entire society). For the rest of this post I mean internal debt when I say debt.
As long as a government does not default on its debt, debt causes a redistribution of wealth from the tax payers to the receivers of interest payments. It is for that reason that I will never understand why people who consider themselves 'left' like debt so much. Germany, since 1949, has payed a multitude of what it was loaned in interest rates. We constantly redistribute wealth from taxpayers to those who own our bonds!
Taxes, just as internal debt, is money which flows from the people to the government who usually promises to spend it in their interest. The difference to internal debt is that those who give the money get nothing in return (except for the promise that the money will be put to good use).
For the purpose of discussing the effects of government spending on the internal economy, we need a very simply model. This model consists of two sectors: the public sector and the private sector. Both sectors consist of nested organizations which, at the lowest level, are individuals.
The public sector uses the government revenue (taxes+debt) to buy things from the private sector. It is controlled by the government to be efficient and not corrupt. The organizations in the private sector are controlled by the respective owners to be efficient and not corrupt. There's not much difference so far. The government officials have just the same incentive (from the electorate) to keep their organizations efficient and not corrupt, as have the private owners (from their desire to maximize profit). The difference is that the struggle for efficiency and against corruption is the more difficult, the larger the organization. And the organizations in the public sector, by necessity, are often very large.
The public and private organizations are nested into each other and they trade with each other. Trade means that they pay each other to do something for each other. The entire system is driven by consumer spending. Ultimately, everything which is produced (goods) and offered (services) needs to have a final benefit for some individual.
The system is also dynamic. At all times, new organizations are formed, old ones destroyed, their interactions change, the way they are nested change, etc. However, most relationships are pretty stable. Most organizations (including the ones on the lowest level, the individuals) don't change their suppliers and customers very often. There's inertia.
Some of the individuals in this system can become unemployed. This means that they don't supply any organization with their labor and thus (usually) can't demand any goods or services because they have no money to offer. When this happens these people are outside the system. They just don't do anything and eventually die due to starvation. The problem is that when you're outside the system you are irrelevant - unless you find a way to become able to supply some organization with your labor; and do this in a way which doesn't cost you money, because you don't have any.
Of course, the case can be made that *somebody* has always an interest in teaching you how to be able to supply him with your labor. In a knowledge-based economy this is, however, much harder than in earlier economies. Trying to turn a 50-year old blue-collar worker into a scientist is a pretty risky thing. That's why the rest of the economy usually gifts the unemployed money so that they don't die and maybe can even educate themselves so that, in the future, they may be able to supply labor and thus demand goods and services again.
The system includes an estimation of the future supply/demand by allowing loans and debt. This means that someone might give you money if you promise to give it, plus an interest, back in the future. And he might take your presumed future ability to repay the loan, considering your ability to now spend the money he just gave you, into account. It's a pretty ingenious system, really.
The system has a tendency to create very rich individuals. These individuals don't actually consume all the money they own, but rather invest most of it. Investing means to spend the money to buy something other people offer (e.g. their labor) and use this to create something which other people (hopefully) demand in the future. If more goods and services are to be created, investment is always necessary. At all times there are usually a few opportunities to invest money. These opportunities are seized in a specific order: the presumably most profitable first.
If you have no idea at all where to invest your money you leave it at the bank. This means that the bank has more money which it can loan, thus driving down the price (interest) the bank will ask for loans. And this will increase the likelihood that somebody, who does have an investment idea but no money, takes up this loan. So, unless you put the banknotes underneath your bed, the money always flows towards some kind of investment.
Stimulus and Austerity
A stimulus plan, as well as austerity, have in common that they create a sudden change in the economy.
With an austerity package, the public sector suddenly demands less and, correspondingly, the government takes up less debt. This means that money which would otherwise have ended up in the hands of the government now ends up at banks. These banks loan the money to some investor and thus the money creates private investment instead of public investment.
With a stimulus package it's really the same: the public sector suddenly demands more and, correspondingly, the government takes up more debt. This means that money which would otherwise have ended up in the hands of the private sector now ends up in the hands of the government. The bank loans less money to some investor but that's ok, because the money now creates public investment instead of private investment.
So the question boils down to who knows better what to do with the money and the answer is not clear. It simply depends on the parts of the public sector which grows (stimulus) or shrinks (austerity). If you have no army, it might be a good public investment to get one. If you have an army which is too large it is a good idea to shrink it.
Of course, the government can also redistribute the money. For example by lowering taxes or by increasing unemployment benefits. But fact is that money never sleeps and as long as there's somebody who has an idea about what to do with a loan and as long as the government doesn't waste the money, it doesn't really make much of a difference whether the public or the private sector spends the money.
You don't believe this? Good for you because its wrong. There are a few reasons.
Globalization means that the money doesn't stay at the local bank. It can go anywhere.
With austerity, the government cuts down on expenditures. Consequently, less loans got to the government and instead somewhere into the private sector. But the money doesn't necessarily go to the local bank where somebody gets a cheaper loan to realize a good investment idea. Instead it goes to Brazil where someone had a really good investment idea. The probability that the highest profit can be made in any specific country is, at all times, low in a globalized world.
That's why reducing taxes on the rich doesn't really do all that much for the local economy. The rich can invest the money in Chinese factories or to buy German cars. Or they can just buy a house in Spain. And they often do!
Public investment programs, however, are better: A new highway can be required to be built by a local company. A new school can be required to be built by a local company. And not only do these actions actually create work for local workers, they even add a school or a highway! And the money which was used to pay the local workers might have ended up somewhere in Russia for another oil pipeline if it hadn't been taxed away or raised with a new bond. That's why, in an open economy, public investment programs are better at fighting unemployment than lowering taxes.
In a way, an open economy is leaking. In a closed economy it doesn't really matter whether the public or the private sector spends the money. It is spent anyway and the only reason to spend it publicly is that something which has to be payed for publicly (like any army) has to be paid. But in an open economy giving somebody money doesn't make him invest it in the local economy. Instead, it can go anywhere; and it does. Investment programs are guaranteed to create local jobs. If they also create something the country needed anyway (like a better school or a new bridge) it's even better.
Another problem is that creation takes more time than destruction and that all parts of the economic system have some inertia.
If you close a government organization, the local workers will be unemployed. Maybe, after a while, they find another job which pays worse. But that's not good for them and neither is it good for society.
Sure, the money which was 'freed' from public use, went to a private bank and was loaned to some private investor. But this investor needs to consider the facts. And the facts are that the workers available were good at working in that now closed public factory; not at some other job. They first need to learn how to work on the new job and while they do, they are less productive. And that's bad for everybody; not only for the workers.
Even worse: good investment ideas take time. Those workers might not actually find a new job soon enough. And while they are unemployed they lose their qualifications. In fact, it's worse: after a year nobody wants to employ them anymore because they don't wash themselves, because they don't own a shower anymore. And they stink.
Of course, if the public factory was full of waste and didn't produce anything useful, not much is lost when it is closed. But modern societies are rather good at controlling waste in the public sector: look at China. There's no reason to assume that just because the government pays you, you work less hard. And there's no reason to assume that a politician whose job depends on the government programs not being wasteful has less incentive to fight waste than a shareholder. The manager who is employed by the government and payed depending on how many goals he reaches as a CEO, is just as effective as the manager who is employed by 30,000 anonymous shareholders. In fact, you could make the case that the publicly employed manager has better and stronger incentives!
But the basic problem is: creation doesn't happen as fast a destruction. And this effect has dire consequences when too much is destroyed too fast. Greece's economy shrank at 7% over the last year. That's a depression; a bad one. The unemployed lose their qualifications ...
The final problem I'd like to mention is inequality. It's not like there's not enough demand on the planet. It's just that most people can't buy all they desire and a few people could not spent all their money even if they tried. Even though money always finds a way into another investment, this investment necessarily is something which is going to produce goods or services which are demanded by someone who has the money to buy them!
That's why it's possible that millions of people want a car, while at the same time millions of people who can build a car are unemployed! If you don't consider this a flaw in the system I really don't know what to say.
At the end of this long, not at all complete and terribly unfocused post, let me say that the current mix of our economic systems is the best this planet has ever seen. We need to remember this while we try to make the economic systems even better.