EU Countries' Spending Cuts, Tax Hikes Hurt GDP Growth

European countries face the impossible dilemma of slashing deficits, debts without cutting GDP growth.

By + More

Merriam-Webster named "austerity" the 2010 word of the year, but its prominence only seems to be growing in 2011, as debt-ridden European nations engage in steep budget cuts and tax hikes to bring themselves out of the red. A new round of second-quarter GDP figures also shows slowing growth in the EU, which makes for a complicated economic situation, as reduced government spending can further stifle growth. Some economists say that, in tackling this dilemma, European governments are focusing too closely on their balance sheets and neglecting to propose real growth policies.

Belt-tightening has become de rigueur in the EU, with Italy the most recent example of the growing family of countries, including Ireland, Spain, and Greece, enacting steep spending cuts and tax hikes. In July and August together, Italy has approved austerity measures worth over 90 billion euros. Those austerity measures are being blamed for economic stagnation in some countries; altogether, second-quarter EU GDP growth was at an anemic 0.2 percent, down from 0.8 percent in the first quarter. Even Germany, the largest economy in Europe, is feeling the pain. The country also famously introduced an austerity package last year, and posted disappointing 0.1 percent GDP growth in the second quarter of 2011, down from 1.3 percent in the first quarter. That growth can be just as detrimental as high levels of debt, say economists.

[See why the pressure is on the Fed now to save the U.S. economy.]

"If Italy had grown at 2 percent, instead of the half a percent that it has in the last couple of years, those concerns [about its fiscal health] would certainly not have been there," says Jacob Kirkegaard, a research fellow at the Peterson Institute for International Economics, a nonpartisan economic think tank. "In many ways, I would argue that for high-debt countries or countries with a lot of existing debt, very low growth prospects are at least as bad as large deficits."

That government spending stimulates growth is one of the core principles of Keynesian economics. But austerity measures were a precondition that countries like Italy and Greece had to meet in order to gain crucial support from the European Central Bank for their ailing bond markets. There is no doubt that high levels of debt sparked bond-market fears in countries like Greece and Italy, which according to the CIA World Factbook had estimated 2010 public debt-to-GDP ratios of 144 percent and 118 percent, respectively. So while countries like Italy, Greece, and Ireland have worrisome debt levels, it seems that for governments to enact austerity measures will only worsen growth problems.

Those countries' almost single-minded focus on debt-cutting could hurt the euro zone economy in ways that go beyond Keynes' theoretical model, says Domenico Lombardi, a senior fellow in global economy and development at the Brookings Institution. "What the debate is lacking at the moment is sufficient focus on growth-enhancing measures," he says. "What we see in Italy and also other countries is emphasis on fiscal adjustment without paying any attention to increase potential growth. That's not going to stabilize markets, not going to reassure investors." In other words, just balancing income and revenue isn't enough; countries also need to show that they are enacting policies to ensure future revenue in order to reassure potential bond buyers.

[Read about President Obama's economic messaging problems.]

Of course, with extremely tight fiscal conditions, spending on short-term programs to promote growth is going to be difficult to impossible. Kirkegaard notes that Spain has undertaken some structural changes to try to promote growth, like raising the retirement age, but that such changes will take time to boost economic output. "These types of structural reforms are generally good for growth, but only in the medium or long term, which is why the growth outlook for growth in europe for the short term is not necessarily very good," he says.