What do Nobel Prize-winning development economist Amartya Sen and IMF chief Christine Lagarde have in common? They both oppose the prevailing orthodoxy that all heavily indebted governments must cut their way back to prosperity as soon as they can.

And they are not alone.

Even as euro zone ministers thrash out the details of a fiscal compact requiring member states to run a more or less balanced budget over the course of an economic cycle, Italian Prime Minister Mario Monti is among those who have warned of the political risks posed by never-ending austerity.

He and others have called for a matching emphasis on growth, an agenda that European Union leaders will attempt to address at a summit in Brussels next Monday.

Sen, an economics professor at Harvard University, said it was folly for governments to bend all their efforts to eliminate deficit spending.

Apart from stoking democratic discontent, the austerity disease sweeping the West was killing the goose that laid the golden egg of growth.

It is very hard to find adequately pragmatic grounds for severe austerity that cuts demand and makes economic expansion much more problematic, Sen said in a lecture at the London Stock Exchange last week.

Sen suggested that some governments were opting for indiscriminate cuts for ideological reasons or even regarded debt reduction as a moral imperative.

If there is one institution that is ideologically associated with austerity in the public eye, it is the International Monetary Fund. Yet the IMF was an early advocate of pump-priming to cushion the 2008 economic slump and it continues to argue against blanket belt-tightening.

On fiscal policy, resorting to across-the-board, across-the continent, budgetary cuts will only add to recessionary pressures, IMF Managing Director Christine Lagarde said in Berlin on Monday.

Yes, several countries have no choice but to tighten public finances, sharply and quickly. But this is not true everywhere. There is a large core where fiscal adjustment can be more gradual.


Business is nervous, too, that reduced state spending on education, infrastructure and services to help the unemployed back into the workforce will eventually hit productivity growth.

In this environment where you need to cut government expenditure, you have to think where we need to keep stimulating and what are the things we can do without. That's a really difficult policy discussion, but it is one we need to have rather than cut everything across the board, said Bart van Ark, chief economist at The Conference Board, a business group.

Broad-based cuts are looming in the United States in a year's time after lawmakers failed to agree on a long-term plan to reduce the federal deficit.

Charles Dumas, an economist with Lombard Street Research in London, said financial markets were underestimating the impact of fiscal deflation that was already under way in the United States and would amount over 2012 and 2013 to an unprecedented 4 percent of GDP.

What we have is a sustained downward drag from government spending, which, if anything, is going to intensify, he said.

The key for investors and policymakers, especially in the euro zone, is to judge how much more austerity is needed to put the public finances back on a sustainable path and how long voters will keep swallowing the medicine.

Overall, the deleveraging process has only just begun, concluded a report by the McKinsey Global Institute, the consultancy's think tank.

Take Spain. The new government has already announced deficit cuts and tax increases worth around 15 billion euros. But it estimates another 25 billion euros of belt-tightening will be needed to hit this year's deficit target of 4.4 percent of GDP, down from 8.1 percent in 2011.

The corporate sector, too, still faces a long haul back to health. Spanish companies hold twice as much debt relative to national output as U.S. firms do, and six times as much as German companies, according to the MGI study.

Debt reduction in the corporate sector may weigh on growth in the years to come, it said.


Deutsche Bank has taken a stab at assessing the adjustments still required by looking at the euro zone periphery's balance of payments.

Deflating domestic demand through budget cuts will help, in conjunction with improved price competitiveness, to correct external imbalances that have ballooned in recent years, locking Greece, Ireland and Portugal out of the bond market.

Deutsche Bank reckons Italy's GDP does not need to fall much further to achieve external balance, but Greece, Portugal and Spain require declines in the order of 25, 20 and 15 percentage points respectively.

Because their exports are not very sensitive to price changes, most of the huge adjustment will have to come through compressing domestic demand, said Thomas Mayer, Deutsche's chief European economist.

Hence, with the achievement of sustainable balance of payments positions still not in sight for most of the problem counties, EMU seems to remain at risk for the forseeable future, Mayer wrote in a report.

Trevor Greetham, director of asset allocation at Fidelity Worldwide Investment, said any attempt by southern members of the euro zone to deflate their way to competitiveness would perpetuate a spiral of falling asset prices, weak growth, climbing government bond yields and rising unemployment.

In this context the latest proposal to enshrine balanced budget amendments in national constitutions amounts to an economic suicide pact, Greetham wrote in the January bulletin of OMFIF, a London think tank.

Today's post-bubble world is crying out for large-scale fiscal easing, not austerity, Greetham said: If some countries need to leave the euro to make this work, it should happen sooner rather than later.

(Editing by Mike Peacock)