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European Union's Cutbacks For Indebted Countries Feed Worries Of A "Second Great Depression"

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DUBLIN — To keep its debt crisis from mushrooming out of control, the European Union is imposing harsh cutbacks on millions of ordinary people in debt-plagued countries like Greece, Ireland and Portugal.

But some economists think cutbacks right now are a mistake that might tip Europe into a dreaded double-dip recession.

How, skeptics ask, will Europe's barely-there recovery withstand the loss of stimulus from sudden, steep austerity measures demanded by the EU? So far the pain includes cutbacks and freezes in teachers' and nurses' salaries, higher retirement ages and heavier taxes on everything from incomes to cigarettes and fuel.

Europe is barely expanding, with only 0.1 percent growth in the fourth quarter in the 16 countries that use the euro, leaving a renewed slide into recession impossible to rule out. And the recession is still on in several countries facing the cuts such as Greece, Ireland and Spain.

"This premature fiscal tightening is the route to the Second Great Depression" – or at the very least, a long period of economic stagnation, warned Simon Johnson, a professor at MIT's Sloan School of Management and a former chief economist at the International Monetary Fund.

Yet markets are leaving EU leaders with little room to maneuver.

Fears of a possible downgrade of Greek debt by ratings agencies sent European stocks lower Thursday and pushed the euro down 0.4 percent to $1.3484, not far off its nine-month low of $1.3444 hit earlier this month and well off its most recent peak of $1.51 from November. Federal Reserve Chairman Ben Bernanke told lawmakers Thursday that the central bank is looking into the use by Goldman Sachs and other Wall Street firms of a sophisticated investment instrument to make bets that Greece will default on its debt.

Robbie Cullen can see both sides of the coin. As a tax collector, he's in the front line of Ireland's battle to bring its runaway deficit under control. But as a divorced dad working two jobs, his own wallet is already at breaking point.

"The debt we've run up as a nation is just unbelievable. A tsunami could hit Ireland and cause less damage," said a red-eyed Cullen, who shifts every day from his civil servant job to moonlighting as a taxi driver in Dublin.

It's a choice he couldn't have imagined a few years ago – before the government's emergency budgets cut his overtime, froze his salary, raised his income taxes and boosted his workload as departing colleagues weren't replaced.

"I can't even keep up with my own debts, never mind the nation's," Cullen said, shopping for cut-rate sausage at a discount supermarket he disdained to visit in better times. "I've got to spend 30 hours a week taxiing just to break even. Something else has got to give. I can't give any more."

Despite the pain its cutbacks are imposing on ordinary people, the conservative Irish government of Prime Minister Brian Cowen has won praise from the European Union and the bond markets for its efforts to cut debt, prices and salaries.

The European Union is demanding austerity in defense of its common currency, which can be undermined by big deficits and would be devastated by a Greek default. The strategy, led by Economic and Monetary Affairs Commissioner Olli Rehn, seeks to reverse deficits spiraling far beyond the euro zone's rule of 3 percent of gross domestic product – Greece's is expected to hit 12.7 percent, Ireland's 12.5 percent, Spain's 11.2 percent and Portugal's 9.3 percent.

The austerity is supposed to deter bond markets from demanding higher interest rates and ultimately sinking state finances.

The cuts are based on a hard fact of economics: the usual path for a country in trouble is to see its currency fall relative to other currencies. That quickly makes it a lower-cost location for business investment and maked its exports cheaper and more competitive, an automatic if painful boost.

But Europe's highly indebted governments such as Ireland, Greece, and Portugal, can't devalue because they belongs to the euro and no longer have their own currency. Latvia is in the same boat, since it has pegged its currency to the euro, which it hopes to join in the next several years.

Without the safety valve of devaluation, countries must instead force down wages and prices to restore competitiveness and get deficits under control. And that's what they're doing, starting with government workers.

Economist Paul de Grauwe of the Catholic University of Leuven in Belgium thinks that panicking markets have the clear upper hand and are forcing governments into slash and burn policies prematurely, before the recovery is self-sustaining enough to endure them. "It's all a question of timing," said de Grauwe.

The EU, said MIT economist Johnson, has to set up creating a crisis management institution, so long as it won't let the Washington, DC-based International Monetary Fund help with crisis lending.

"If you don't want them, fine, but get a move on and do something else," said Johnson.

Cuts have been the hardest in tiny Latvia, where a European Union-sponsored bailout has led to 30 percent salary cuts for police officers and teachers.

Ireland's cutback strategy so far seems to be appeasing bond investors. Ireland has imposed income-tax hikes ranging from 1 percent to 3 percent and slapped a 7 percent charge on the wages of more than 700,000 state-paid workers – including nurses, teachers and taxmen like Cullen – to fund their pensions.

"I lost near 10 percent off my wages just like that," he said, snapping his fingers. "But they also took away overtime pay, bonuses, all these supposed `extras' that you actually relied on to get you through Christmas. I'm easily 30 percent worse off. But my maintenance (alimony) to the ex-wife hasn't dropped a cent."

Like Ireland's economy as a whole, Cullen is still struggling to "deleverage" – or cut his own debt levels from the boom years. He says he's struggling himself to maintain payments on his own suburban home – unsellable in a market that has a glut of property and trapped a fifth of households in negative equity.

Some politicians in the affected countries are warning of the dangers of cutting too far too quickly. The Socialist leaders of Greece and Portugal are trying to hold the line at hiring and pay freezes, while avoiding outright pay cuts. Greek unions held wide-ranging protest strikes Wednesday, shutting down flights, schools and curtailing medical services.

In Spain, shoppers are bracing for a planned 2-point hike in national sales tax to 18 percent and a two-year increase in the retirement age to 67. Pro-austerity economists say this isn't nearly enough.

Neighboring Portugal plans to freeze the pay of its 675,000 civil servants this year and prune payroll by at least 7.5 percent within four years. Freezing salaries means an effective pay cut as Portugal's prices, particularly for utilities, keep rising.

"Luxury goods, travel, treats, vanity items will all have to go," said Helena Ferreira, a 46-year-old single mother of two teenage sons who works in the immigration service in Lisbon.

"I'll have to buy clothes in the sales and avoid buying the brand names the kids want. Even with food – those little things we spoil ourselves with – I'll have to cut back."

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AP Business Writers Barry Hatton in Lisbon, Daniel Woolls in Madrid and Gary Peach in Riga, Latvia contributed.

(This version CORRECTS Corrects graf 7, Fed looking into bets that Greece will default, NOT Goldman role in reducing apparent size of deficit. ADDS photo link. Moving on general news and financial services.)

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