MARKET HAS UPPER HAND IN DEFICIT BATTLE / THE WALL STREET JOURNAL ( HIGHLY RECOMMENDED READING )

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FEBRUARY 4, 2010, 3:55 A.M. ET.

Market Has Upper Hand in Deficit Battle .

By RICHARD BARLEY And SIMON NIXON

If the European Commission thought its much-caveated approval of Greece's latest plan to rein in its bloated deficit would draw a line under the country's debt crisis, it should think again. Greek stocks, bonds and credit default swaps rallied initially Wednesday but then reversed direction. In reality, the market is calling the shots, and will ultimately decide whether Greece's attempts to cut its deficit by over 9 percentage points of GDP by 2012 are credible. Other highly-indebted countries should take note.

A few months ago, the Commission's stamp of approval might have been enough to reassure investors that Greece's fiscal crisis was manageable. But the best that could be said for Wednesday's ruling is that the market now believes a future bailout for Greece is more likely since the European Union would find it harder to abandon Greece if the country had made an effort to fulfill its obligations. In the short-term, that could help keep a lid on bond yields, reflecting the reduced risk of a default.

Greece's fate has implications for the global debate over the timing of the withdrawal of fiscal stimulus. The International Monetary Fund, for instance, recently warned that countries face the risk of a double-dip recession if they pull back on emergency support measures too quickly, a cry echoed by many politicians. But if bond markets decide that sustained public spending and high deficits in some countries risk creating an unsustainable debt position, then they will take matters into their own hands.

Spain and Portugal are clearly next in the market's crosshairs. The cost of insuring their debt against default rose Wednesday even after the EU ruling on Greece. Also vulnerable is the U.K., where the political rhetoric on the deficit has become more confused in recent days, with the opposition Conservative party seeming to step back from promises to make quick, sharp cuts. Schroders on Wednesday became the latest big investor to warn that the debt markets are in no mood to forgive politicians who fail to grasp their concerns.

Faced with this pressure from the markets, policy makers in highly-indebted countries will increasingly face an unpalatable choice: cut voluntarily, and take the risk the recovery is damaged; or have cuts forced on them in the midst of a market crisis.

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