Austerity: Is the European Union changing tack?

Anti-austerity protestors took to the streets of Madrid again last week to proclaim, "not this way"

Has austerity become a dirty word? And more important than the language, has the policy changed? The tone of the public debate has certainly softened in recent months.

Take the European Commission's President Jose Manuel Barroso. The Commission is seen in some parts of Europe as the high priesthood of austerity - more so even than the International Monetary Fund - yet Mr Barroso had this to say: "While I think this policy is fundamentally right, I think it has reached its limits."

Those limits are political ones, the willingness of the population in countries undergoing austerity to tolerate the economic pain.

The IMF too has shown some flexibility. Speaking about Britain, the IMF's managing director Christine Lagarde told the BBC's Hardtalk programme, "now might be the time to consider" slowing the pace of austerity.

Just as striking is the view at the world's biggest bond investment fund, Pimco. Managing director Bill Gross told the Financial Times last week that austerity in the short term was not the way to produce growth.

"You've got to spend money," he said. Contrast that with his warning back in 2010 that British government debt was too high, he then said it was "resting on a bed of nitro-glycerine".

Policy drawbacks

So the debate has changed, but among policy makers at least it is not about where they are going; it's about how fast countries get there.

The ultimate destination was and still is lower annual government borrowing needs - 3% of national income in the case of European Union countries and a stable level of government debt.

The reason the pace is changing is that austerity has been accompanied by slower economic growth than was expected and persistent deep declines in economic activity in some countries such as Spain and Greece.

Apart from the obvious impact on living standards, the economic weakness makes the objective harder to reach.

Slower growth means less tax revenue and more spending on social welfare, so borrowing does not come down as rapidly as it would in a stronger economy.

There is also a mathematical issue. One of the key measures of the health of government finances is the ratio of total debt to national income. One central objective for managing governed finances is to stabilise that ratio.

Failing to do that is what is usually meant by unsustainable government finances. A shrinking economy means the denominator in that ratio is falling, which in turn means the ratio itself gets bigger.

Weaker 'multipliers'

The combined impact of this economic weakness and the continued government borrowing is that the debt ratio has continued to rise in many developed countries.

To take some examples, in Greece it rose from 112% of GDP in 2008 to an expected 180% this year, in Ireland from 44% to 122%, and in Britain from 52% to 93%.

One possible reason for this disappointing outcome is that the impact of the austerity might be greater than was forecast. The IMF has done some research suggesting that might be the case.

Cutting spending or raising taxes can have a larger than one-for-one impact. The money that a public sector worker does not spend has an effect on the business whose goods and services he or she does not buy and so affects what that business spends.

The technical term is "fiscal multipliers" and the IMF research suggests they may be larger than normal in a weak economy and when interest rates are already very low which makes it more difficult for central banks to offset the impact that austerity has on demand.

It is not a universally accepted view, but it is making itself felt in policy-making circles.

Breathing space

Mr Barroso's remarks were an admission austerity policies were running out of steam

A recent IMF report argued that for many countries, reducing borrowing should ideally be deferred to the future, when economic recovery would enable it be done at less cost to the economy; to put it more technically, at a time when the fiscal multipliers are lower.

The report did acknowledge that some countries might have little choice but to cut quickly if they have difficulty borrowing in the markets.

There is also the political issue mentioned by Mr Barroso. If the public will not at least grudgingly acquiesce to an austerity programme it becomes politically unachievable.

For now at least the prospect of a government debt crisis coming to a head in the eurozone has receded.

For those that need to raise money in the financial markets, including Spain and Italy, borrowing costs are relatively affordable, certainly far below the levels they hit when the financial market strains were at their worst.

It gives them some breathing space and suggests that the markets might be ready to tolerate them taking a bit more time to stabilise their debts.