Austerity debate flares as Europe recovery fades

FRANKFURT, Germany -- Europe's economic recovery is in danger. Governments are under pressure to save it, but struggling with political obstacles and disagreement among themselves over what to do.

Instead, the region is pinning its hopes -- once again -- on the European Central Bank, which is expected to launch new stimulus measures if the economy gets any worse.

Europe's lack of growth is looming larger and larger, however, and the ECB says it can't save the economy alone.

For more than five years since the eurozone hit turbulence over too much debt in 2009, governments' answer has been to raise taxes and restrain spending. And there's been some progress. Deficits have shrunk, and countries that needed bailout loans are slowly getting their act together.

But second quarter growth was zero, after only four quarters of measly expansion. While unemployment in the United States has fallen to 6.2 percent from 10 percent at its peak in Oct. 2009, Europe's is at 11.5 percent -- still near last summer' 12 percent. The risk is that the eurozone remains stagnant for years -- bad news not just for its people but also its three major trading partners: the U.S., Britain and China.

As worries spread, the debate over austerity versus growth is sharpening again. EU leaders will meet Oct. 6 to discuss growth, while the ECB will hold a policy meeting Thursday at which it is expected to flag its willingness to announce more stimulus such as bond purchases.

ECB president Mario Draghi is ringing the alarm.

He says the central bank can't do it all alone and that governments should dial back austerity, within EU rules aimed at restraining deficits. "It would be helpful for the overall stance of policy if fiscal policy could play a greater role alongside monetary policy, and I believe there is scope for this," Draghi said in a speech last week. Government spending can help boost growth by providing demand when the private sector is struggling.

Draghi's not the budget boss, however. Each of the eurozone's 18 member governments decides its own spending. Germany, Europe's biggest economic and political power, and Chancellor Angela Merkel are sticking with the emphasis on austerity. Countries with extremely high debt, such Italy, are under pressure to keep the lid on spending.

Here's a look at Europe's dilemma.

IN THEORY: Some economists think much more needs to be done. Francesco Giavazzi and Guido Tabellini at Bocconi University in Milan say the 18 eurozone governments should do a coordinated 5 percent tax cut, spread their budget balancing efforts over an extra 3-4 years, and issue long-term bonds that the ECB would buy. That's unlikely to happen, as such steps would run into legal and political objections.

But the proposal is a sign of how much stimulus some think is needed.

If YOU BUILD IT: Draghi backed a proposal by Jean-Claude Juncker, the incoming head of the EU's executive commission, for a $394 billion fund to invest in infrastructure such as roads, bridges and ports, drawing on existing EU funds and private investment. Governments, particularly Germany with its balanced budget, could do the same. If they want to, governments could borrow cheaply. Bond interest rates are very low. Germany's 10-year bonds yield a rock-bottom 0.89 percent. Even Ireland, bailed out in 2010, faces yields under 1.8 percent -- below even 10-year U.S. Treasurys at 2.34 percent.

"From a market perspective, they have an enormous amount of room," said Jacob Funk Kirkegaard, an economist with the Peterson Institute for International Economics in Washington, DC. "There is a good argument that many are making that governments should make the most of that room and take out some more debt and invest more in infrastructure, education and other things."

So far Merkel and pro-austerity Finance Minister Wolfgang Schaeuble aren't budging. Schaeuble says yes to investment, but only without new borrowing. He's facing resistance from within the government, however. The Social Democratic Party, a partner in the coalition government with Merkel's conservatives, is pressing for more investment spending, and an expert commission is looking at the issue.

TAKE IT EASY: A smaller scale but more likely approach would be for Germany and other EU leaders to look the other way if countries fall behind in reducing their deficits to meet European Union rules. That would avoid obliging governments to make growth-killing, short-term tax increases just to get the deficit down. France, for instance, has already admitted it won't make its budget targets for this year.

CUTTING SMART: Draghi urged countries to be smart in cutting their budgets -- for instance, to spare spending on long-term investment that helps growth in future years, and not to just rely on growth-killing tax increases. France's President Francois Hollande is doing something along those lines, as his government is pushing 30 billion euros in business tax cuts through 2017, offset by 50 billion in spending cuts. It's half stimulus, half austerity.

Yet the proposal was denounced as German-style austerity by Economy Minister Arnaud Montebourg. Montebourg was fired and Hollande vows to press ahead.

STRUCTURAL REFORMS: Beyond budgets, economists say there is much that France and Italy -- two of the weaker economies in the eurozone -- can do to help growth by enacting more flexible rules on hiring and firing.

So far, there's been some progress, but major reforms remain undone. Italian Prime Minister Matteo Renzi has vowed to tackle them -- over the next 1,000 days. Uncertainty about France and Italy remains a key source of weakness, according to economist Holger Schmieding at Berenberg Bank. "Businesses are withholding investment decisions until they see how much prime ministers Renzi and Valls can deliver," he says.

DEAL? Ultimately, Germany's attitude may soften if it sees France and Italy getting serious about reforms.

Kirkegaard said the question is finding a way for Germany to back a joint investment fund. "There's no chance that Germany is going to do such a thing if they are afraid that the French and the Italians are not serious about reforms ... It reduces the moral hazard that Germany is always concerned about -- that the Germans write a check and the Italians and the French spend it and they don't do any reforms."

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Hinnant contributed from Paris.