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IMF Predicts European Recession; Slowed Global Economy

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WASHINGTON — Global leaders are sharply at odds over how to rescue Europe from its escalating debt crisis: Should they focus more urgently on economic growth or on budget cuts?

The disagreement presents another obstacle to solving the region's financial crisis, and it pits one of the world's most important lenders against Europe's strongest economy.

The International Monetary Fund said Tuesday that encouraging growth should be policymakers' highest priority. It issued the warning on a day when the lending organization cut its estimates for global growth this year and predicted a recession in Europe.

But Germany, the economic engine of Europe, is afraid it could get stuck paying much of the cost to bail out its weaker European neighbors. It is pushing instead for budget cuts, which the IMF says could weaken growth further and undermine market confidence.

The IMF is already lending to the region's bailout fund and has a lead role in monitoring the progress that nations such as Greece make in reducing their government deficits. Germany, meanwhile, is also a large contributor to the bailout fund.

"There is a fundamental divergence in points of view," said Eswar Prasad, a former IMF official and economics professor at Cornell University. The IMF's emphasis on growth is "a subtle but important shift in the prioritization of the reforms."

On Tuesday, the IMF reduced its forecasts for global growth this year to 3.3 percent. That's below the 4 percent pace that the IMF projected in September. It's also lower than the estimated 3.8 percent growth for 2011 and the 5.2 percent in 2010, the year after the U.S. recession ended.

The 17 nations that share the euro will shrink 0.5 percent this year. In September, the IMF had predicted 1.1 percent growth for the region.

Europe's recession should have only a modest impact on the United States. The IMF projects 1.8 percent growth for the year in the U.S., unchanged from its September forecast and equal to its 2011 estimate.

If Europe doesn't take several steps recommended by the IMF, such as reducing its emphasis on budget cuts, the 17 nations that share the euro could contract at a much faster pace, the fund said. That could possibly plunge the rest of the world into recession.

"The world recovery, which was weak in the first place, is in danger of stalling," Olivier Blanchard, the fund's chief economist, said at a news conference. "The epicenter of the danger is Europe, but the rest of the world is increasingly affected."

Governments should avoid extreme austerity measures – spending cuts and tax increases – in weaker economies, such as Italy and Spain, the IMF said in an update to its World Economic Outlook. And healthier European countries whose governments are facing lower interest rates "should reconsider the pace" of their short-term budget cuts.

IMF Managing Director Christine Lagarde made a similar argument Monday during a speech in Berlin. The 187-member IMF conducts economic analysis and provides emergency lending to countries in financial distress.

Germany is expected to grow this year, albeit at a slow pace. It has had to foot a big chunk of the bailout for Greece, Ireland and Portugal.

Chancellor Angela Merkel has pushed other countries to restructure their economies, as Germany itself did about 10 years ago. But her priority right now is to get a broad agreement among European countries to limit their government deficits.

German leaders fear that "if these countries don't get their public finances in order ... then Germany will end up footing the bill," Prasad said. "That doesn't play very well in Germany."

Austerity measures likely won't work without faster growth, Prasad said. More growth can boost tax revenue and reduce government spending on social programs.

Greece is cutting its budget deficit, Prasad said, but that's causing its economy to contract sharply. As a result, its government debt is increasing relative to the size of its economy, despite the cuts. That makes it harder for Greece to pay off its debts.

Many European governments do need to cut deficits, Blanchard said, "but at an appropriate pace."

It may take two decades or longer to pay off the debts accumulated during the 2008 financial crisis and global recession, Blanchard cautioned. He notes that it took that long to pay off the debts Europe ran up during World War II.

European governments should also build up the region's permanent bailout fund, Blanchard said. That's necessary to support larger nations, such as Italy and Spain, which are paying high interest rates on their debts.

The IMF's projections are based on the idea that Europe's leaders will take those steps, Blanchard said. If they don't, Europe's economy will shrink by much more and "the world could be plunged into another recession," he said.

Last week, the IMF said it is seeking $500 billion to boost its own resources in the event more lending is needed in Europe or elsewhere.

European banks, meanwhile, are cutting back on lending in order to increase their capital reserves, the fund said. That's likely to hammer Central and Eastern European economies this year, which depend heavily on European bank loans.

Blanchard said banks should shore up their finances by raising more capital, rather than cutting back on loans.

"The good news," Blanchard said, is that "with the right set of measures, the worst can definitely be avoided, and the recovery can be put back on track."

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