Austerity — spending cuts, tax increases — is standard economic medicine for overborrowed countries. It may work for individual countries or even a few countries at a time. But if most of Europe embraces austerity, the logic backfires. Economic growth slows; recession may reemerge. Lower tax revenue makes it harder for countries to service their debts. As this becomes obvious, the financial crisis feeds on itself. Investors sell the bonds of weak countries, sending up their interest rates and making the debt burden heavier.
This is the monster now stalking Europe. Last week, rates on 10-year Italian and Spanish bonds exceeded 6 percent, roughly four percentage points above rates on 10-year German bonds. Meanwhile, the outlook for economic growth is deteriorating without offsetting gains in the rest of the world that might boost Europe’s exports.
So Europe now faces a crisis that is at once financial, economic, diplomatic, political and social. The vaunted “European model” of generous welfare benefits is steadily reneging on its promises. Naturally, this is highly unpopular. Strains among countries are worsening as all seek to shift blame and costs to others.