Andrew Gawith: Fighting off sovereign debt crisis

Photo / Thinkstock

Opinion

Many European governments are cutting public spending to contain burgeoning debt and unsustainable deficits.

The plans vary from lifting the pension age (France) to wide-ranging and eye-watering cuts to almost every area of government spending (Britain).

The austerity programmes are being driven by sovereign debt worries and more particularly the risk that some of the smaller European countries will be unable to repay the public debt they have issued.

A sovereign debt crisis was averted this year by an emergency funding package backed by the big and fiscally sound economies, but one of the quid pro quos was that those governments in trouble had to commit to fiscal crash diets.

The UK government is aiming to slash total spending by almost a quarter over the next four years. Ireland is staring at public spending cuts equivalent to more than 5 per cent of GDP over the next four years and that figure is likely to increase given the latest bank bailout package.

Spain and Portugal also have packages aimed at cutting public spending by more than 5 per cent of GDP over the next three years, while Greece has been forced to cut public spending by around 11 per cent of GDP over the next two years.

Germany and France have announced relatively meagre cuts despite their public commitment to fiscal rectitude.

Interestingly, the emphasis from most European governments has been on reducing expenditure rather than raising taxes.

In Greece, it seems that simply collecting already legislated taxes would be a huge help in reining in the deficit given pervasive tax evasion. The focus on reducing spending implies a smaller role for governments in many of these economies - and for some countries that change may be long-lasting.

The first impacts of these cuts are obvious: less money for departments and ministries forcing many programmes to be scaled back or abandoned. One of the immediate consequences is that people lose their jobs, stop paying tax and start drawing the unemployment benefit.

The irony is that fiscal contraction does little to shrink deficits in the short run - Ireland was one of the first countries to embark on fiscal austerity but its fiscal deficit is getting larger not smaller and not just because of the latest bank rescue package.

In the meantime the dislocation that spending cuts cause individuals and communities hit by unemployment and loss of services is politically corrosive.

The theory is that people dropped by the public sector will find work in the private sector providing goods or services that businesses and ultimately consumers are prepared to pay for. That could take some time.

Basically what we are seeing is the real cost of the global financial crisis. The cost of bailing out the banks is now flowing through to a steep increase in non-discretionary government spending - that is, paying the interest on the public debt.

That means governments are having to slash discretionary spending and investment programmes as debt servicing costs have become a bigger share of static or dwindling revenue.

But the problem goes deeper than the financial crisis in many countries. Cheap and abundant credit over the first half of the decade encouraged governments (as well as households and businesses) to take on debt to finance projects and programmes, which have subsequently been shown to be of less value than expected.

Greece is probably the best example of this behaviour - its underlying fiscal deficit was already well out of whack by the time the financial crisis hit. The worry, expressed most strongly by US economist Paul Krugman, is that fiscal contraction at this time could tip economies back into recession and that could accentuate the fiscal and sovereign debt issues.

Better to pump prime economies back to robust growth - a much more favourable environment for reducing deficits and debt.

It is difficult to see how some of these economies will escape a further period of recession given the anaemic growth in consumer spending, which could easily be undermined by rising unemployment. Combine that with lower levels of capital spending and shrinking public spending and it's easy to conclude that some of these economies will contract further over the next year or two.

A real and disturbing effect of another period of economic contraction is that it will feed already well established resentment towards immigrant groups who are seen as the biggest recipients of social spending and are often the first and worst affected by recession.

Extreme right wing political groups are on the rise in Europe - tough economic conditions are fertile ground for ugly politics. President Nicolas Sarkozy's expulsion of Roma people (gypsies) from France and German Chancellor Angela Merkel's statement that multiculturalism had "utterly failed" mark a significant loss of tolerance in these countries and encourage the rise of right wing parties throughout Europe.

In contrast to Europe the US is focused on stimulating economic growth - fiscal austerity is a second order priority.

Getting the US economy up off the floor is proving more difficult than many expected and it is almost certain that the Federal Reserve will embark on another round of quantitative easing - printing money.

The aim is to create some inflation and encourage more spending, production and employment. But the increased supply of US dollars is undermining its value - the currency recently hit a 15-year low against the yen.

Given the US' fiscal position, as well as its colossal and expanding public debt, a depreciating currency and inflation are important palliatives which are not available to most fiscally challenged European economies.

* Andrew Gawith is a director of Gareth Morgan Investments www.garethmorgan.com