MADRID — After more than a year of aggressive budget cutting by European governments, an economic slowdown on the continent is confronting policymakers from Madrid to Frankfurt with an uncomfortable question: Have they been addressing the wrong problem?
The campaign to reduce government deficits has come in response to a European debt crisis that could endanger the global banking system. And the budget cutting has been coupled with a reluctance by the the European Central Bank to stimulate economic growth like the Federal Reserve has in the United States; the ECB has instead raised interest rates twice this year to contain inflation.
Those steps have sucked hundreds of billions of dollars out of a European economy that may be edging towards recession.
Such a downturn, by choking off government revenues and increasing the demand for public services, could put struggling countries such as Spain and Italy at risk of missing the very deficit-reduction targets that budget cuts and other austerity measures were meant to achieve.
In the United States, political and economic leaders are facing the similar dilemma of how to rein in the massive federal debt by enacting deep and immediate spending cuts without undermining already anemic economic growth.
This is the challenge confronting the White House as President Obama seeks to strike a balance between his promise to help tame the national debt and his new jobs initiative, which he wants to announce next week before Congress. So, too, a newly appointed bipartisan committee of lawmakers must figure out by Thanksgiving how to shrink the federal deficit by least $1.2 trillion even as many economists urge the government to do more to prevent another recession.
The perils posed by government debt are even more pressing in Europe. Bond markets are testing countries — and indeed the euro zone as a whole — with higher borrowing costs. This is putting pressure on governments to show they can control deficits and pay their bills. At the same time, deficit control measures have been fast and sharp — pay cuts, layoffs, tax hikes and other steps that are a drag on growth.
This approach has been successful in helping to keep debt problems that began nearly two years ago in Greece from spreading to the continent’s largest economies. And there’s widespread agreement among economic analysts and officials that debt levels have become unsustainable in some countries and are raising concerns about the health of banks that hold European government bonds.
But the one-size-fits-all approach in Europe may ignore the trade-offs between government austerity and growth.
In Spain, for instance, where the parliament this week is voting to place constitutional limits on government deficits in a bid to reassure global investors, some analysts say the country is taking the wrong medicine. Spain’s debt level remains lower than even that of Germany, the continent’s strongest economy and one of the world’s benchmark credit risks. But Spain’s unemployment rate is more than double that of the United States, and some economists say the country needs a healthy dose of policies to restore growth, not constrain it.
The International Monetary Fund, which has generally encouraged “fiscal consolidation” in euro-zone countries, has noted that budget cutting undermines growth and employment. The impact is even more pronounced if many countries are cutting at once and central bank policies are not geared toward growth — just the path Europe is following, according to the IMF.
With the euro-zone economy slowing and governments aggressively cutting, the ECB may need to concede its rate increases and tight money were a mistake, Peter Vanden Houte, an analyst at ING, wrote Wednesday in a research note. “Loose monetary policy seems to be the only medicine left to prevent a painful fall back into recession,” he said.
Recent statistics showed that the combined economy of euro-zone countries nearly stalled from April through July, with growth of just 0.2 percent. Germany’s economy, one of the main props of the region, grew just 0.1 percent. Analysts project Spain’s annual growth at about 0.7 percent for the year, far below prior government estimates of 2.3 percent. That may force a choice: further belt-tightening, or missing the deficit targets that international markets now expect.
IMF Managing Director Christine Lagarde recently warned that government officials could be overreacting to the debt crisis.
“Slamming on the brakes too quickly will hurt the recovery and worsen job prospects,” she wrote in a Financial Times column. International investors “dislike high public debt — and may applaud sharp fiscal consolidation. . . . They dislike low or negative growth even more.” Lagarde did not, in the column, name countries that could slow their deficit-cutting efforts.
Across Europe, this debate is growing urgent. Britain, where public discontent erupted in riots this summer, is struggling with how to balance budget discipline against the social risks posed by a dormant economy. Iceland, after two years of painful economic contraction, got a pass from the IMF this week to begin spending more money to nurture its recovery.
Both countries are outside the euro area. Inside the euro zone, the doctrine remains cut first and deal with growth later.
The initial debt crisis, which unfolded in Greece in the spring of last year, was acute — an approaching default by a government on bonds sold to international investors, including many banks throughout Europe. An international rescue was arranged for Greece, followed by bailouts for Ireland and Portugal as they too came under attack by investors.
The spreading contagion prompted European leaders to call for commitment to tame public spending across the euro zone. In return for backing the bailouts, Germany, the continent’s strongest economy, demanded that other governments adopt austerity measures.
But the immediate rush to trim deficits, some analysts now suggest, may be diverting attention from politically difficult structural decisions needed to clear the way for growth. These could include selling off public companies in Greece and consolidating Italy’s millions of small firms into more efficient enterprises. In Spain, it could mean curbing the power of trade unions.
“Spain’s is not a fiscal problem,” said Gail Allard, a professor of economics at Spain’s IE Business School. Like many analysts in Spain, Allard noted that the country’s overall debt level remains below the average for euro-zone nations.
But the financial crisis, which started in 2007, and the subsequent recession hit Spain’s banking industry hard. Real estate tax receipts, a major source of government revenue, fell sharply, and annual budget surpluses turned to deficits in excess of 10 percent of annual economic output. The overall debt level, which had been considered reasonable, began to increase fast.
Allard and other analysts agree that the government needed to take action. But they say the focus should have been on restoring growth by, for instance, revising labor policies that hamper investment and hiring, rather than on cutting deficits in an economy that was already reeling.
Investors were still comfortable lending money to Spain. So there was little reason, analysts say, for Spain to seek to reassure them by raising sales taxes — especially at a time when local demand was plummeting and unemployment was rising above 20 percent, the highest in the region. Investors may have respected the budget cuts, but they also would have taken note of pro-growth structural changes, these analysts say.
“Unless you start with some sort of labor market reform, it is not going to change anything fundamental about the Spanish economy,” Allard said.