Emergency efforts by Italy and France to implement more unpopular austerity measures could prove to be a tinderbox for the euro zone's largest economies, even as governments face growing global pressure to stem the continent's spiralling debt crisis.
Italian Prime Minister Silvio Berlusconi announced a combination of tax hikes and spending cuts on Friday to meet European Central Bank demands to slash the country's deficit and bolster its fiscal outlook, though the plans faced resistance by some local government officials.
After being propped up by the ECB's new bond-buying program this week, Italy is under intense pressure to fulfill the central bank's demand that it balance its budget by 2013.
"Our hearts are bleeding. This government had bragged that it never put its hands in the pockets of Italians but the world situation changed," Mr. Berlusconi said, while insisting the emergency measures were "fair."
The package, adopted by emergency decree, imposes austerity measures worth €20-billion ($28-billion) in 2012 and a further €25.5-billion the following year through a mixture of public spending cuts and higher taxes, Mr. Berlusconi said.
Italy is just one of several euro zone countries trying to slash debt as investors rebel, along with protesters in many regions of the monetary union. It's a delicate balancing act for governments. Economists say implementing too much fiscal austerity too quickly can cause economies to contract as tax revenues also tumble. Such an outcome risks making a bad fiscal situation even worse.
The new austerity package features special levies on high-income earners and tax initiatives, among other measures. As a result of those moves, Italy's budget deficit is expected to fall to 1.4 per cent of gross domestic product in 2012 from 3.8 per cent this year, and be eliminated in 2013.
The austerity package must now be approved by parliament within 60 days. It was adopted on the same day Italy's central bank disclosed that public debt topped €1.9-trillion for the first time in June – the after-effects of Italy chipping in to bail out Portugal and Greece.
As the European debt crisis spread, the ECB intervened to buy up Italian and Spanish debt in a bid to drive down borrowing costs. Still, the tougher austerity measures are sure to spark anger among voters.
This is Rome's second austerity package in as many months, though the government has cited the fact that the financial situation has eroded markedly. France, meanwhile, is also facing a political pressure cooker as it mulls even deeper cuts to government spending while a slowing economy threatens its ability to slash its deficit.
Disappointing second-quarter GDP numbers on Friday are raising prospects of a budget shortfall this year, dialing up the urgency to squeeze out more government cost savings amid lingering speculation that France remains vulnerable to losing its stellar triple-A credit rating.
While European stocks benefited from a ban on short-selling of some shares, experts suggested the effect would only be temporary.
"It is hardly under control and the markets are barely stabilized," said Carl Weinberg, chief economist at High Frequency Economics.
"We've had a lot intervention by the ECB this week in stabilizing the bond market for Italian and Spanish bonds, but the credit default swaps aren't fooled and prices of credit default swaps remain at record highs for both Italian and Spanish bonds."
The next market shock, he said, could come on Monday when the ECB discloses how much it has spent on sovereign debt purchases this week. That will be followed by initial estimates for the euro zone's second-quarter GDP on Tuesday, a release that will also include estimates for key member countries like Italy, Spain and Germany.
"Of course, the more disappointing GDP is, the harder it is to implement budget deficit reduction if tax revenues are reduced," Mr. Weinberg added.
The fiscal woes plaguing several euro zone countries are complicating efforts to solve the continent's 21-month-old debt crisis.
In particular, France's exposure to debt in the euro zone's troubled nations (including Italy, Greece, Ireland, Portugal and Spain) has come under intense scrutiny this week.
A downgrade of France's credit rating would make it extremely costly for France to borrow enough to help bail out its neighbours. That's a concern because France and Germany have committed to approving changes to bolster the European Financial Stability Facility (EFSF), a €440-billion rescue fund designed to bail out insolvent countries, by the end of September.
French President Nicolas Sarkozy and German Chancellor Angela Merkel will hold talks next Tuesday to discuss improvements to the euro zone but economists say reaching a permanent political solution could take years.
Despite political resistance across the continent, the protracted debt crisis is slowly pushing the 17 countries of the euro zone toward evolving into an integrated fiscal union, said Craig Alexander, chief economist of Toronto-Dominion Bank.
That includes the eventual creation of a euro bond, joint debt that is backed by all countries that use the euro.
Mr. Alexander said it is becoming painfully clear that simply sharing a common currency and interest rate is insufficient to ensuring the euro zone's long-term sustainability. Its survival is imperative to the global economy because the continent's economic integration would simply be too costly to unwind.
"We need to understand that France and Germany are not being altruistic when they bail out Greece, Portugal and Ireland," Mr. Alexander said. "They are not doing it because they want to. They are bailing out these countries because they are trying to protect their own financial systems."
With files from Reuters and Associated Press