Debate Rages Over Benefits of Fiscal Austerity

The Spanish government’s new package of tax increases and spending cuts throws a spotlight on an increasingly contentious debate about whether fiscal austerity in Europe is further damaging the patient’s health rather than leading to recovery.

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Yields on Spanish government bonds dipped, a sign that investors have given the measures– the fourth such package since the government was formed seven months ago – a vote of confidence.

Among Europe’s leaders and economists there is more disagreement.

The election of the socialist François Hollande to the French presidency in May helped tip the political debate in the euro zone towards promoting growth rather than austerity at all costs, a stance supported by Mario Monti, Italy’s prime minister. But even Mr. Hollande is now proposing unprecedented public spending cuts on top of hefty tax rises for business and the wealthy.

Even the International Monetary Fund has expressed concern about the pace of efforts to reduce governments’ borrowing at a time when domestic demand is contracting, unemployment rising sharply and the supply of credit dwindling fast.

“Still-high deficits, rising debt ratios and the volatility of financial markets all argue for continued fiscal consolidation, especially in advanced economies, but the weakened global outlook puts policymakers in a delicate position.

“Too little fiscal consolidation could roil financial markets, but too much risks further undermining the recovery and, in this way, could also raise market concerns,” the IMF said in its Fiscal Outlook in April.

At times such as today when there is significant spare capacity in many countries and output is far below its potential – what economists call an “output gap” – fiscal consolidation can lead to an even bigger hit to economic output than it might otherwise, the IMF noted.

“The debt dynamics of Spain are not helped by the present stance,” says Gerard Lyons, chief economist at Standard Chartered.

“It is akin to being in a hole and being asked to dig deeper. Spain needs growth– it needs demand, not austerity.”

But Marco Annunziata, chief economist at General Electric, says Spain is simply doing what it needs to justify the 100 million euros ($122.3 million) promised from the EU to shore up its teetering banking sector.

“Madrid’s austerity measures send a very important signal that, just as Spain is receiving additional support from the euro zone, it is in turn making an additional effort to keep its fiscal policy on track.”

Spain faces a particularly unholy combination of challenges because of the size of its banking sector relative to the economy and the depth of banking losses. Indeed, this may well explain the contrasting performance of several European states – French GDPhas been growing more rapidly than that of the UK, where the banking sector is significantly bigger.

“From an economic point of view, Spain is the one place where you might criticize what Europe’s ‘core’ countries are doing,” says Richard Barwell, chief European economist at Royal Bank of Scotland. The combination of bank deleveraging and austerity has exacerbated capital flight at a time when Spaniards need it badly to stay at home, he says.

Outside Spain, the EU is right to demand fiscal consolidation on the current scale because without that pressure, badly needed reforms – more competition for labor markets and industry generally – simply will not happen, Mr. Barwell says.

Germany, whose political leaders are most insistent on austerity, may not realize how austerity across Europe may actually hurt its economy because it is dependent on exports to the euro zone, notes Vicky Pryce, former joint head of the UK’s Government Economic Service.

“Germany has benefited hugely from purchases by the periphery economies. Sales to the rest of Europe are already suffering and it’s just going to be reinforced by these austerity measures.”