The right kinds of austerity policy The policies of fiscal austerity now being pursued throughout Europe have come under their strongest attack yet. Double-dip recession is eroding voters" confidence that belt-tightening is the best way to recover prosperity. Elections in France and political upheavals elsewhere are tilting the balance of opinion among policy makers away from unwavering commitments to deficit cuts. More than ever, clarity is needed about where and which kind of austerity is needed. Many forces buffet the world's economies, and economic policies must be correspondingly nuanced. Simple-minded approaches to deficit-cutting will not do, and no single austerity policy is right for all countries. This is why the Financial Times has consistently given qualified support to the British government's fiscal strategy while criticising the excessive zeal for deficit-cutting in some eurozone states and in the US policy debate. Editorial Some commentators - many of them American, such as the economist Paul Krugman - condemn Europe's fiscal consolidation strategies indiscriminately. There is no doubt that the direct effect of tightening fiscal balances is contractionary. But quite apart from the fact that long-term growth requires sound public finances, a lax fiscal policy also has two negative effects on short-term growth. One is the risk of self-fulfilling panics in bond markets, with the crippling effect on both the public and the private sector that we see in affected countries. The other, more slow-burning but just as corrosive of growth, is that sustained large deficits and rapidly mounting debt can chill the animal spirits of business. Any good done by deficit spending can be lost to retrenchment by private employers. Economic research can tell us something about the direct effect of fiscal stimuli on growth. It has less to say about the consequences for bond-market psychology - self-reinforcing and thus inherently unpredictable - or business confidence. What is certain is that whether the negative effects will outweigh a fiscal boost to growth varies from country to country. In the US, the case for fiscal stimulus is strong. In a relatively closed economy government spending lifts domestic demand without much leakage. The $10tn Treasury market is also so big that it is largely a captive one. It is virtually impossible for investors to abandon it, as their equanimity towards last summer's downgrade showed. An accommodating central bank helps. Similar considerations apply to Japan, if to a lesser degree. In contrast, small and middling countries, including all European states, face a different trade-off. They would only enjoy a muted demand stimulus from unilateral fiscal relaxation; so enmeshed are they in international trade, much of the effect would seep across their borders. Size also makes bond investors a greater flight risk. Even the Italian sovereign bond market - well supported by domestic investors and the world's third-largest - is, it turns out, easy to exit en masse. This does not justify the eurozone's official ideology of universal austerity. Many euro countries have ample fiscal space and should wield deficit spending as a tool to counter slow growth or recession. Only those with very large deficits, huge debt burdens or both have no choice but to cut, and cut hard. That includes the three states with rescue programmes, but not Spain. In Britain, fiscal laxity would do more harm than good (though how the cuts fall could be improved). Its structural deficit is exceeded only by the US, Japan and Ireland among advanced countries. Investors who take fright can easily shift money abroad. Critics of the ruling coalition's policy say low gilt yields mean investors want the government to borrow more. But this treats markets" welcome of a multiyear deficit reduction plan as if it were a prayer for the high deficit to be maintained. They also say the Bank of England, unlike the European Central Bank, can be trusted to keep gilt yields low. But the BoE is independent. It would take a true catastrophe for it to be willing to buy as many gilts as it takes to guarantee the government low borrowing costs. Even if it did fill the shoes of panicking gilt investors, such a scenario would hardly contain funding costs for UK banks abroad or make British businesses eager to invest and employ. Only globally co-ordinated fiscal policy can improve the trade-off faced by small and middling economies. A true growth compact - which should be global, not just European - could let risky states run a slightly less tight ship if safe states bore the brunt of boosting demand. This would take greater leadership than we have yet seen.