The gruel of austerity after feast of stimulus

Asa Fitch: As Europe moves swiftly from spending to saving, the Gulf must be pleased it has already addressed the majority of its debt issues.

"Americans have always been able to handle austerity and even adversity," the late James Reston, a two-time Pulitzer Prize-winning journalist who rubbed shoulders with many a powerful politician during the Cold War, once wrote. "Prosperity is what is doing us in."

The excesses of an ill-founded prosperity having long ago done them in, Americans and Europeans can only hope Reston is right and they are able to handle austerity with aplomb. The global financial crisis has cost developed countries trillions of dollars and will probably cost trillions more. Governments will ultimately have to repay funds used to prop up their financial systems and, in Europe, avoid sovereign debt defaults.

That, naturally, means austerity. As economists have warned since the early days of the crisis, governments will have to slash budgets to plug deficits taken on to pay for bailouts and reduce runaway debt. Government employees will lose their jobs. Public spending on health care, social services and pensions are all under threat. Taxes are likely to go up. Governments have begun to make clear that spending cuts are in the offing, hard as those may be to impose on a population at a time when political careers are at risk. Widespread discontent over rollbacks of government services and the prospect of public-sector job cuts has already boiled over in Europe, where unemployment is in the double digits in many countries.

When the French president Nicolas Sarkozy's government came out in favour of raising the retirement age from 60 to 62 last month, mass strikes ensued. Greece wants to save US$30 billion (Dh110.19bn) over three years by freezing public-sector salaries, scrapping bonuses, increasing taxes and privatising state-owned industries. The result? Riots broke out last month. Ireland, Belgium, Germany, Portugal and Spain have also seen public unrest over newly introduced austerity measures.

The US has endured no populist revolt, but austerity is on the way there, too, despite the strength of the dollar and the willingness of investors to snap up the country's debt. Ben Bernanke, the Federal Reserve chairman, said last week "the federal budget appears to be on an unsustainable path" and hinted that fiscal policy ought to combat government healthcare spending that is rising rapidly as the population ages.

Inevitable as austerity always was, it is in some ways remarkable how quickly developed countries - especially those in Europe - transitioned from massive spending on bailouts to strict belt-tightening. The public outcry over austerity in Europe has surprised few onlookers, given the continent's embedded tradition of generous social safety nets. But it came mere weeks after politicians negotiated a $1 trillion bailout for debt-laden euro-zone countries, and well before any stimulus could exert a real economic effect.

Austerity came quickly in Europe for two reasons. First, countries in the EU are required to keep deficits to below 3 per cent of GDP, a threshold many had been exceeding despite calls from European Commission leaders to control budgets. Second, IMF and EU aid to Europe's struggling countries was contingent on hefty cuts. Spain, Greece, Italy, Portugal and Ireland had to take austerity measures. Those factors have put Europe in an odd - some might say awkward - position, forcing countries to pay a fiscal price for economic stimulus before they even finish spending the stimulus money. To be sure, it will take at least a year before recently announced budget cutbacks have an effect on deficits, simply because countries craft annual budgets well in advance of the budgeted spending. Insofar as the rhetoric has begun over cuts, however, austerity is already taking its political toll.

The bigger question now, however, is whether European countries' enforced fiscal prudence will ultimately unhinge Europe's recovery from recession, leading to the oft-grumbled-about double-dip. That is a trickier conundrum. A decline in government spending would dent economic growth, but some economists believe pulling in the fiscal reins will not fully halt the recovery under way. The weakness of the euro during the debt crisis should also boost exports and help GDP as companies and consumers in countries with strong currencies buy more European goods for less.

"Even when fiscal tightening will become more meaningful in the coming years, past episodes suggest that deficit cutting does not necessarily have a negative impact on growth when the economic upswing has become strong enough," Thomas Herrmann, an economist at Credit Suisse, said in a recent note, concluding that worries over a renewed recession "appear to be overdone". Gulf countries, at least, have little to fret about in Europe's recent troubles. The region's dollar-linked currencies are strong for now, meaning dirhams and dinars alike can buy more goods from Europe than before. That should help combat inflation in the GCC, which relies on imports for a vast array of goods and even health services.

Global economic instability is not good for the Gulf, of course. That was made clear enough in the first recession cycle, when investors fled from riskier emerging markets to safer US treasuries and gold, sending prices to all-time records in recent months. As hard-hit international banks pulled back on lending, too, some companies could not secure necessary refinancing for loans. That led to Dubai World's $23.5bn debt restructuring. Last month, Dubai World agreed with its core group of creditors to terms on the restructuring.

But as long as Europe's worries do not push the global economy back on to shaky ground, economists expect local factors to hold sway in the Gulf. Here, the main risk is that other large companies may need to renegotiate debts before the financial kinks have fully unravelled. "Some parts of southern Europe must be quite envious that Dubai has quietly got on with reaching an agreement with its creditors and rescheduling its debt," Gary Dugan, the chief investment officer at Emirates NBD's private bank, said in a note to clients. "The main risk to the local markets' rally remains from any further restructuring of any other Dubai-based, government-related entities. With the local markets still lagging the recovery … of the global markets since the start of 2009, we believe there is the scope for further good absolute and relative performance."

In an era of austerity, the UAE may have more prosperity to look forward to than European countries because it has already addressed many of its debt issues. [e-mail]