Financial markets, worried though they are about anemic growth, simply will not let them — even if the outcome is an even slower rate of expansion that risks driving debt-to-GDP levels higher, prompting more anxiety that, in a vicious circle, further undermines growth.

“At the moment, the markets have priced in a very slow growth environment for the foreseeable future but have not yet priced in recession,” said Andrew Milligan, head of global strategy at Standard Life Investments in Edinburgh.

“They would welcome measures that even moderately raised that slow growth path for the next few years. But markets would react very poorly if they thought governments were giving up the battle for fiscal control,” he added.

Against this unforgiving market background, Spain on Friday followed the lead given a week ago by Italy and approved additional spending cuts to help meet its deficit-reduction target.

France, alarmed at the thought it could go the way of the US and lose its top-notch AAA credit rating, plans cuts of its own by the end of the month.

Britain’s public finances turned out better than expected in July, but the Treasury immediately said that the US downgrade and continued turbulence in Europe made it vital for the government to stick to its planned cuts.

Even in Australia, with gross government debt of just 24 percent of gross domestic product, there is no political appetite to increase deficit spending to counter the threat of a global downturn. Prime Minster Julia Gillard said this week she was “absolutely determined” to return the budget to surplus by 2012/13.

Some analysts would like to see governments with fiscal policy space make more vigorous use of it.

“Why have politicians taken on board this whole idea that the answer is fiscal austerity at a time when unemployment is a huge issue? I’m puzzled by it,” Deepak Gopinath, a Delhi-based director of Trusted Sources, an emerging markets research outfit.

Economists at Morgan Stanley, who this week lowered their 2012 growth forecast for the euro zone to 0.5 percent from 1.2 percent, acknowledged that the sovereign debt crisis not only ruled out pump-priming but could force governments to tighten fiscal policy further to meet their deficit targets.

“Such a pro-cyclical policy stance might be necessary to regain market confidence — in a way similar to central banks having to regain credibility in the 1980s by pushing economies into recession to break the engrained inflation habit,” they said in a report.

As things stand, the fiscal changes planned this year and next by 20 major economies are likely to reduce GDP growth cumulatively by about 1.25 percentage points, according to a study by two International Monetary Fund economists.

The 20 account for over 70 percent of global GDP. 

The impact will be felt mainly domestically. For instance, the German drag on growth from its fiscal consolidation will reach 1 percentage point with another 0.25 percentage point shaved off the growth of Germany’s trading partners, Anna Ivanova and Sebastian Weber wrote on the VoxEU.org website.

So what can be done to cushion the blow to growth?

The government in Madrid sugared the pill of extra spending cuts by halving the sales tax on new house purchases until the end of the year. It also said it would approve measures next Friday to boost jobs.

US President Barack Obama is exploring a package of pro-growth measures to be unveiled next month, while some investors expect a strong signal from Fed Chairman Ben Bernanke next week that the US central bank will relax monetary policy afresh if the economy keeps deteriorating.

The problem is that the law of diminishing returns is kicking in. The Fed’s second round of asset purchases, flagged by Bernanke exactly a year ago, worked like a dream for a while in boosting share prices and confidence.

But it merely brought forward economic growth and could not ultimately stave off an economic relapse that was the background to this month’s market turmoil. The impact of car-scrappage and appliance trade-in schemes is similarly fleeting.

“There is a growing realization that short-term palliatives are not the solution that’s needed,” Milligan said.

He said markets would welcome well-crafted strategies to boost the West’s flagging competitiveness and productivity. Deregulation, export incentives, apprenticeships for the unemployed, infrastructure investment and increased lending to smaller firms would all raise potential growth rates.

The problem is that such deep-seated changes that challenge vested interests are a tough nut to crack. Witness the failure of the European Union’s Lisbon Agenda of structural reform. It also takes years for such reforms to translate into the stronger growth craved by governments and markets alike.

“Politicians and societies have not realized the nature of the crisis that we’re living through,” Milligan said.

“It is not ‘one more push’ that will get us through. Debt deleveraging problems will be with us for years to come.”