Europe indicates it's sticking with austerity. But is that working?

This week European Council President Herman Van Rompuy reaffirmed the European government's commitment to the austerity measures it has required of its struggling periphery. But experts say that austerity has only worked to an extent, due to too little focus on growth and a lack of actual reforms.

Mr. Van Rompuy on Monday met with US Treasury Secretary Jacob Lew in Brussels. But while Mr. Lew and the US encouraged Europe to shift away from its austerity policies towards more growth-oriented ones, Van Rompuy said that Europe was committed to its austerity-centric approach.

"European economies face high levels of debt, deep structural medium-term challenges and short-term economic headwinds that we need to confront," he said. "We have made significant progress in correcting internal imbalances in the euro zone since the second half of last year. But there is no room for complacency."

But much of Europe – particularly the five eurozone countries known as the PIIGS: Portugal, Italy, Ireland, Greece, and Spain – continues to suffer. Three years after the EU and IMF intervened by promising financial backing and long-term economic growth in exchange for the short-term pain of austerity measures, one of the countries, Greece, is in a spiral dive while three others – Spain, Portugal, and Italy – are seriously struggling.

'No concern for growth'

"For all countries, and particularly for Greece and Italy, the focus has been on the short-run increases in tax revenues and not on the long-run consequences of austerity," says Evi Pappa, an economics professor at the European University Institute in Florence.

"For economies in recession, sheltering growth is a key factor. But the Greek government, for instance, has been single-mindedly concerned with collecting taxes no matter what, and there has been no concern for growth," she says.

The Greek economy, whose malaise eventually infected neighboring Cyprus, reacted to austerity in a very different way than what the EU and IMF had anticipated. Hit by lower wages, unemployment and uncertainty, Greek businesses and citizens sharply reduced spending. That led to an overall reduction in incomes and consumption, thus causing Athens to collect lower tax revenues than expected. In turn, that prompted further tax increases and spending cuts by the government, effectively trapping the economy in a declining loop.

According to projections made by the International Monetary Fund at the beginning of the austerity policies in 2010, the Greek GDP should have been $323 billion in 2012. Instead, it was only $255 billion, 21 percent lower.

In addition, there is increasing evidence that the very main goal of austerity – setting a stable trend towards balanced budgets – has not been achieved.

Data compiled by Ugo Arrigo, a professor of government finance at the University of Milan Bicocca, show for example that the Italian government, through its austerity measures, expected to improve its net debt position by $64 billion in 2012. However, when the final 2012 data was released in February, the actual improvement turned out to be only $19 billion, less than 30 percent of the original goal.

The situation is not better elsewhere. While the IMF estimated at the beginning of austerity policies, in 2010, that the PIIGS would on average carry a debt to GDP ratio of 106 percent by 2012, the latest data put the actual figure closer to 125 percent.

Re-evaluating austerity

"The reality is that it was not easy to see it coming. Economists did not have much experience of austerity policies in developed countries," says Giles Merritt, secretary general at the Brussels-based think tank Friends of Europe. "The EU turned out to be a lot more sensitive to those policies than previously thought."

Europe's institutions have not been blind to the complaints. The IMF itself published two papers in October and January – one authored by its chief economist – in which it discussed how European economies contracted more than it had originally forecast.

And the IMF and the EU have held an ongoing re-evaluation of the policy options available. For instance, the deficit targets for several countries, including Spain, Ireland and Portugal, have been relaxed in an attempt to foster growth.

And while so far the costs of austerity have been higher and the rewards lower than expected, the policy also brought about some positive change. Although the recession meant that government finances did not improve, the bite of austerity did force governments to start cutting some of the inefficient spending.

"Government finances in the euro periphery are structurally better," agrees Uri Dadush, director of the International Economics Program at the Carnegie Endowment.

That bodes well for the PIIGS' economic health in the future, says Vincenzo Scarpetta, a political analyst at Open Europe, a London based think tank. "In the longer term, structural reforms will yield results," he says. "In Italy the pension reform was a good one, and there were other reforms that at least partially did what was needed."