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Are austerity measures killing Europe's recovery?

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?

business Updated: Sep 04, 2011 21:12 IST
Howard Schneider

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 European Central Bank to stimulate economic growth like the Federal Reserve has in the US. Instead, the ECB has 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 raising 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 US, political and economic leaders are facing the similar dilemma of how to rein in the huge federal debt by enacting deep and immediate spending cuts without undermining already anemic economic growth.

The perils posed by government debt are even more pressing in Europe. Bond markets are testing countries - and indeed the eurozone 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.

IMF MD 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."

In Exclusive Partnership with The Washington Post