Austerity may not be enough to save the EU's weakest links

Analysts at the credit ratings agency Moody’s Analytics have issued a stark warning that even with budget deficit programmes and savage cuts in public spending across the eurozone some of the weaker peripheral nations will still default on their debts, requiring a "restructuring".

They say: "It is hard to escape the conclusion that austerity will not end the debt crisis, and that restructuring may be necessary, as Germany's Chancellor Merkel has indicated."

Arguing that Europe is the "weakest link" in the global economy, they say that the fortunes of Asia and the West will diverge further next year, and that the United States' prospects have "improved only somewhat" with the passage of the recent budget deal in Congress.

But China also represents a threat to growth around the world. Reflecting recent caution from the Bank of England on the flow of funds into emerging markets, the Moody’s Analytics economists add: "Although China will continue rapid growth, it faces downside risks from inflation and a real-estate market correction. Despite these problems, our baseline outlook for recovery assumes Europe and China will go through orderly restructurings that will prevent further financial panic."

Overall, downside risks to the global outlook have increased since the start of 2010, say the analysts, adding: "Even if these risks do not materialise, growth in the world's largest economies is set to slow in 2011 before picking up in 2012."

That is the consensus view among international bodies such the IMF. But Moody's is much more gloomy about the chances of Europe being able to make it through the next few years without a major dislocation – even comparing the situation with the Argentine banking crisis of 2001, which saw riots as the value of people's savings was wiped out by 75 per cent in what was in effect a default as the country failed to maintain its link with the US dollar. Similar stresses in nations such as Greece are foreseen by the Moody's team.

In a gloomy note, Moody's states: "The largest risks to global recovery stem from Europe's sovereign debt crisis.

"The amount of austerity needed to correct Europe's imbalances may be as politically unsustainable as it was for Argentina in 2001. Even in Britain, which has not had a full-blown sovereign debt crisis, new fiscal austerity measures have sparked demonstrations by students facing higher university fees."

There is also a blunt criticism of the EU's leaders: "Both European bondholders and policymakers face problems in 2011 because officials clung too long to the belief that government austerity plus bailout financing was sufficient to handle debt overhang in periphery countries.

"The recent reconsideration of that position by German Chancellor Merkel and the ECB has come too late to avoid draconian cutbacks, higher unemployment, and declining output in the periphery countries."

Most worryingly, there is also the suggestion that the current austerity packages may not work economically even if they find political acceptance: "Europe remains the weak link, not just because of its sovereign debtcrisis but also because even its fiscally stronger states – France, Germany and the UK – are tightening fiscal policy. With growth still below potential, this could push the region's more vulnerable economies into recession. Europe might still be able to muddle through, but an orderly restructuring of sovereign debt is looking more desirable as the damage from budget cuts mounts and as high-debt countries struggle to escape recession."

Andres Carbacho-Burgos, an economist at Moody's and author of its global outlook, concludes: "Europe seems to have abandoned fiscal stimulus measures as a macroeconomic policy tool, while the US has yet to find a way to use a fiscal stimulus in a way that is debt-neutral over the long term.

"The world economy continues to diverge as 2011 begins, in ways that could produce serious side-effects."