EU outlawing Keynes? And they definitely approve of the ESM…

BRUSSELS (Reuters) – European leaders struggled to reconcile austerity with growth on Monday at a summit that approved a permanent rescue fund for the euro zone and was trying to put finishing touches to a German-driven pact for stricter budget discipline.

Officially, the half-day 27-nation summit was meant to focus on ways to revive growth and create jobs at a time when governments across Europe are having to cut public spending and raise taxes to tackle mountains of debt.

But disputes over the limits of austerity, and Greece’s unfinished debt restructuring negotiations with private bondholders, hampered efforts to send a more optimistic message that Europe is getting on top of its debt crisis.

Leaders agreed that a 500-billion-euro European Stability Mechanism will enter into force in July, a year earlier than planned, to back heavily indebted states. But Europe is already under pressure from the United States, China, the International Monetary Fund and some of its own members to increase the size of the financial firewall.

The risk premium on southern European government bonds rose while the euro and stocks fell on concerns about a lack of tangible progress in the Greek debt talks and gloom about Europe’s economic outlook.

Highlighting those fears, Spain’s economy contracted in the last quarter of 2011 for the first time in two years and looks set to slip into a long recession.

France halved its 2012 growth forecast to a mere 0.5 percent in another potentially ominous sign for President Nicolas Sarkozy’s troubled bid for re-election in May. Prime Minister Francois Fillon said the cut would not entail further budget saving measures.

Conservative Spanish Prime Minister Mariano Rajoy, attending his first EU summit, said Madrid was clearly not going to meet its target of 2.3 percent growth this year. That has raised big doubts about whether it can cut its budget deficit from around 8 percent of economic output in 2011 to 4.4 percent by the end of this year as promised.

European Commission President Jose Manuel Barroso hinted Brussels may ease Spain’s near-unattainable 2012 deficit target after it updates EU growth forecasts on February 23.

Italy, rushing through sweeping economic reforms under new Prime Minister Mario Monti, was rewarded with a significant fall in its borrowing costs at an auction of 10- and 5-year bonds, despite double-notch downgrades of its credit rating by Standard & Poor’s and Fitch this month.

But Portugal’s slide towards becoming the next Greece – needing a second bailout to avoid chaotic bankruptcy – gathered pace as banks raised the cost of insuring government bonds against default and insisted the money be paid up front instead of over several years.

The yield spread on 10-year Portuguese bonds over safe haven German Bunds topped 15 percentage points for the first time in the euro era. It cost a record 3.9 million euros ($5.12 million) to insure 10 million euros of Portuguese debt.

OUTLAWING KEYNES?

With Britain standing aloof, most of the other 26 EU leaders were set to approve a fiscal pact to write balanced budget rules into their national law, despite economists’ doubts about the wisdom of effectively outlawing deficit spending.

“To write into law a Germanic view of how one should run an economy and that essentially makes Keynesianism illegal is not something we would do,” a British official said.

European Parliament President Martin Schulz told the leaders the new fiscal treaty was unnecessary and unbalanced, because it failed to combine budget rigor with necessary investment in public works to create jobs.

The 17th summit in two years as the EU battles to resolve its sovereign debt problems was called to shift the narrative away from politically unpopular austerity and towards growth.

Negotiations between Greece and private bondholders over restructuring 200 billion euros of debt made progress over the weekend, but were not concluded before the summit.

A Greek official said Prime Minister Lucas Papademos would give the summit a brief report on the situation and meet German Chancellor Angela Merkel on the sidelines.

Until there is a deal, EU leaders cannot move forward with a second, 130-billion-euro rescue program for Athens, which they originally pledged at a summit last October.

Germany caused outrage in Greece by proposing that a European commissar take control of Greek public finances to ensure it meets fiscal targets. Greek Finance Minister Evangelos Venizelos said that to make his country choose between national dignity and financial assistance ignored the lessons of history.

The German call won cautious backing from the Dutch and Swedish prime ministers. But Merkel played down the idea of placing Greece under stewardship, saying: “We are having a debate that we shouldn’t be having. This is about how Europe can be supportive so Greece can comply, so there are targets.”