Europe's Debt Dilemma

London - When a patient is on life support, it's not typically advisable to squeeze the oxygen hose. But that's just what European policymakers may be forced to do. The region's economy contracted by 4.1% last year and is expected to show growth of just 0.7% in 2010 as stimulus spending takes effect. With government debt growing and Greece and Ireland flirting with default, though, leaders across Europe may have to cut some of that oxygen—risking a tumble back into recession. "If cuts come too quickly, they could stifle the recovery," says Jamie Dannhauser, an economist at consultancy Lombard Street Research.

The ratio of overall debt to gross domestic product in the European Union—a key indicator of fiscal health—will jump to almost 80% this year, according to the European Commission. While that's shy of the 89% level in the spendthrift U.S., it's up from 60% in 2007. For this year, the combined deficits of European governments will hit 6.7% of GDP, more than double the 3% mandated under EU law. In Greece, Britain, Latvia, and Spain, the 2010 shortfall is in double digits.

Taxes must be raised, big infrastructure projects scaled back, and bureaucrats' pay cut if debt is to be reduced. But many experts fret that governments may be moving too fast. "A balance needs to be struck between a relatively weak recovery and rising debt levels," says Sebastian Barnes, senior economist at the Organization for Economic Cooperation & Development in Paris. "Some countries find themselves in extremely difficult positions."

That's particularly true for the so-called PIIGS: Portugal, Italy, Ireland, Greece, and Spain. Fears of default have spurred international ratings agencies to downgrade their sovereign debt, making it costlier for them to raise money. "Uncertainty is poison for market confidence," says Alistair Milne, a finance professor at the Cass Business School in London.


Ireland, where the credit-fueled housing market shrank by a fifth last year and the economy contracted 7.5%, slashed $5.8 billion from its 2010 budget of $87 billion. That includes lower unemployment benefits, reduced subsidies to parents of young children, and pay cuts of 5% to 15% for government workers. Greece plans to free up $6.5 billion by freezing civil servants' pay, raising taxes on high-end property, and increasing levies on cigarettes and liquor by 20%. France aims to raise $4.4 billion annually by charging $25 per metric ton of carbon dioxide emitted by cars, home furnaces, and factories. Britain will probably increase its retirement age and cut welfare programs, though nothing is likely to happen before a national election this spring.

Mounting voter anger could temper politicians' plans. Strikes are planned in Greece, laborers in Spain have balked at lower jobless benefits, and Irish workers have taken to the streets to protest the cutbacks. "Short of selling our kidneys, we don't know how we're going to [pay our bills]," says Brian Condra, 38, a hospital orderly and father of three from the Irish coastal town of Drogheda. He expects his family's take-home pay to drop by some $360 monthly, and that's on top of $500 a month in new taxes introduced last year. "I went around for the last four months needing new shoes," adds Condra, who clearly has a gift for pungent language. Now "I will have to be walking around in my bare feet."

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