Southern Europe digs in against further austerity, as IMF calls for relief

But the EU has little room to give, as Europe waits for signals from September elections in Germany – the ultimate decider of Europe's economic direction.

The players in Europe's economic crisis look increasingly deadlocked, as ailing countries in the south – with support this week from the International Monetary Fund – rebel against further deficit-cutting measures advocated by the wealthier nations to the north.

At the heart of the rebellion is Spain. The conservative government of Mariano Rajoy, which is negotiating an extension to its unreachable deficit targets with the EU, is vocally rejecting European Commission pressure to impose more austerity, from tax increases to public sector cuts.

Rather, Spain wants its partners to do more at the regional level to stimulate growth by easing targets and relaxing austerity rather than simply to be dictated to by northern lenders, led by Germany.

Ultimately, the ability of the EU to balance conflicting forces will determine the pace of Europe’s recovery. But many are aware that conflicting priorities – and intervening politics – mean it's unlikely that much meaningful action will be taken and the waiting game will continue.

“...There is a balancing act to be performed by the EU. You can’t overdo austerity because you kill growth, but on the other side you can’t go full growth because countries like Spain have no room to increase their deficit,” says Matteo Cominetta, London-based European economist with HSBC. “Markets won’t be happy if deficits increase.”

The IMF renewed calls on Europe, the UK, and US governments to ease austerity. Spending cuts are the “wrong way” to reduce the deficit and austerity has to implement “gradually, building measures that limit damage to demand in the short term,” it said in its World Economic Outlook released this week.

The Spanish situation

Spain says it’s coordinating with the EU to set up more deficit-cutting measures, to be announced by the end of April, in exchange for more flexibility. The EU Commission last week suggested an additional sales tax increase, salary cuts to public servants, and even more flexibility to fire employees, building on a previous labor reform that has swelled unemployment to 27 percent.

Spain, which has won market trust and praise from its peers for its commitment to austerity, flatly rebuffed the suggestions. Budget Minister Cristobal Montoro Friday rejected any new tax increase or salary cuts to public employees, while Finance Minister Luis de Guindos ruled out significant reforms to labor laws after meeting his counterparts over the weekend in Dublin.

Spain wants a two-year extension until 2016 on its deficit target of 3 percent of GDP, which would imply raising its target for 2013 to more than 5.5 percent, from its current goal of 4.5 percent, which is already unreachable.

Portugal also won a seven-year extension to pay back the 78 billion euro bailout it signed onto in 2011, but the government this week will likely spell out how it will meet an EU condition that it delivers on its proposed spending cuts, even though the country’s Constitutional Court recently ruled against a slew of government-approved austerity measures.

The EU also agreed on Monday to transfer Greece more funds from its bailout package, but only after the government agreed to fire 15,000 more public employees.

Balancing carrots and sticks

The EU recognizes periphery countries’ efforts and realizes that external factors, more than country policies, are undermining their economies. As such, the European Commission in effect is already offering relief by looking the other way at stubbornly high public deficits. And periphery governments all admit EU-imposed austerity policies are painfully necessary.

Consequently, Portugal secured more favorable loan terms, despite wildly missing its targets. Italy is not facing too much pressure, either, despite a growing debt problem, while Greece and Ireland are also getting more breathing room.

Brussels also worries that voter rejection of austerity – via election of governments that resist deficit-cutting even more than present ones – could further politically and economically threaten the EU. Italy’s institutional stalemate illustrates growing impatience among the southern Europeans.

And the EU’s botched bailout negotiations with Cyprus, which at the end undermined trust in the broader EU block, are a powerful reminder of the systemic risks involved in balancing carrots and sticks, especially when dealing with core countries like Spain and Italy.

Europe’s inability to rewire its economy also tops the agenda in upcoming International Monetary Union, World Bank, and G-20 upcoming meetings. Meanwhile the US recovery appears solid, albeit slow, and Japan is controversially but decisively injecting massive liquidity and stimulus to overcome the stagnation.

“The entire world understands that you can’t reduce the debt burden with budget cuts under current conditions,” said investment guru and civil society philanthropist George Soros. “If you reduce the budget, you reduce the gross domestic product in greater proportion, and you worsen the problem. This is recognized all over except in the euro zone,” he told El País in an interview published on Monday.

No room on deficit

The EU though has little oxygen to offer, especially this year as Europe holds its breath for September elections in Germany, which is the ultimate decider of Europe's economic direction and could see a change in leadership.

“A lot was done in 2011 and 2012. You don’t need much more austerity for 2013 in the backdrop of adverse conditions,” says Gilles Moec, senior economist of Deutsche Bank.

“What we don’t know is if the EU is ready for structural deficit cuts," he adds, referring to long-term deficit gaps that will not narrow easily even with an economic recovery. "What seems to be happening is ‘don’t ask don’t tell,’” he says, citing European leaders’ inability to coordinate economic policies largely due to national political calculations.

In the meantime, the EU balancing act will continue.

“They can’t ask for more austerity, but they can’t relax it more either,” says Mr. Cominetta. “Whether this means that the Commission will be more lenient, I doubt it. Looking forward, Europe will continue to accept considerable slippage, but will not verbally accept much higher deficit numbers.”