Europe's Debt Dilemma: Will Cuts Stifle Growth?

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Paul White / AP

A broker looks up at the large screen at the Stock Exchange in Madrid, Wednesday May 12, 2010

Oh how brief was the joy. On May 10, financial markets reacted euphorically to the creation of a nearly $1 trillion fund to assist euro-zone economies imperiled by massive debt. Since then, however, bourses have seesawed between moderate losses and gains as buyers contemplate what happens next. The biggest question now being debated in capitals across the European Union: How can national governments who no longer face as great a risk of default bring their deficit and debt levels down without choking off the spending that's fueling already feeble growth?

That conundrum puts the E.U. between a rock — trying to tackle government debt — and a hard place — appeasing the market forces that helped transform Europe's debt crisis to a full-blown emergency. In recent months, hedge funds have bet against Greece's ability to honor its staggering debt, which made it more expensive for Athens to borrow money to pay creditors. But it also raised the risk the contagion of doubt spreading to heavily indebted Portugal, Spain and Italy. To address the threat of that contagion possibly dragging down the entire euro zone, E.U. leaders and the International Monetary Fund belatedly forged a $950 billion package of funding, ready to come to the rescue if any other economies using the single currency are brought to the brink of insolvency by their own debt — or if moves by financial markets increase that possibility. However, by agreeing to the creation of that crisis fund, euro economies have implicitly committed themselves to taking action against the soaring, debt-increasing spending that sparked the current calamity in the first place.

Logically — and cruelly — financial markets that only two days ago were reassured that the risk of sovereign default had been minimized are now pondering how national governments are going to cut spending without falling back into recession. At Wednesday's close, all European exchanges were up slightly after a modest contraction on Tuesday — mirroring activity in Asian markets — as buyers wondered whether looming action by governments to cut deficits and debt would blow holes in their economic boats.

"You need to cut spending at the top of the economic cycle, not at the bottom — even if that's what markets, political backers, or partner governments are all telling you to do," says Eric Heyer, economist and deputy director at the French Economic Observatory in Paris. "If you cut spending across the board before you've attained sufficient growth to confirm sustained recovery, you'll sap what little expansion you do have, increase unemployment as business reacts to that, and in the end wind up with less revenue and more outlay than you saved with your cuts. The figures show we're far from sustained recovery."

But it's getting harder for governments to wait for that recovery before they start reducing budgets, especially as most nations that were at the fore in creating the E.U.'s crisis fund are themselves loaded with debt. German Chancellor Angela Merkel's center-right coalition took a beating in the May 9 election in the key state of North Rhine-Westphalia, in large part due to voter fury at Germany agreeing to partially fund Greece's debt rescue. In an attempt to quell the public's anger, Merkel was forced to renounce long-promised income tax cuts. And on May 11, conservative members of her ruling coalition vowed they would massively slash spending to reduce the budget deficit forecast of 6% this year. The next day, Spain did just that, with Prime Minister José Luis Rodríguez Zapatero announcing that he had added another $19 billion in cuts to the $63.7 billion he's already planned in his effort to reduce the country's budget deficit from 11.2% of GDP in 2009 to 3% in 2013.

In France, meanwhile, the government of President Nicolas Sarkozy has announced a freeze in spending levels and is preparing the public for additional cuts, all while denying that these are signs of a new era of austerity. The government is also resisting calls — for now, at least — from leftist opponents to repeal billions in tax cuts that were passed in the wake of Sarkozy's 2007 election victory. Heyer at the French Economic Observatory notes that for Sarkozy to fulfill his promises to Brussels to reduce France's expected 2010 deficit of 8% to 3% in 2013 — a total reduction of $127 billion — he'll have to find $102 billion that's currently unaccounted for.

"The only other source is growth, and it's not there yet," Heyer says, noting the first-quarter 2010 expansion of just 0.1% in France, 0.2% in Germany, and Spain's recession-exiting 0.1%. "Austerity before recovery risks renewed recession in most countries. Austerity by all countries at once is virtually sure to take them all down."

The answer, Heyer says, is to halt deficit rises by freezing spending levels, and target cuts to areas not contributing to growth until recovery returns and reforms can begin in earnest. That's a go-slow approach the markets may not like, but one that seeks to avoid a double-dip recession they would hate even more.