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European leaders shift thinking on austerity, ready to give countries time to close deficits

Three and a half years into its government-debt crisis, there are signs that Europe is adopting a gentler approach toward austerity.

Political leaders aren't backing away aggressively from budget cuts and higher taxes, but they are increasingly trying to temper these policies, which have stifled growth and made it harder for many countries to bring their deficits under control.

The European Union is relaxing its enforcement of deficit limits until the region's economy turns around; countries that were bailed out by their European neighbors are being given more time to repay loans, easing the pressure to cut budgets further; and financial leaders, including the head of the European Central Bank, say it's time to place more emphasis on reviving growth.

"There has clearly been a shift in thinking," says Christian Schulz, economist at Berenberg Bank in London.

After the crisis broke out in late 2009, governments dramatically slashed spending — either to meet conditions for bailout loans, or to reassure jittery bond markets that they were trustworthy borrowers. This fiscal belt-tightening was introduced to help countries reduce their deficits and pave the way for critical financial aid.

Promises of austerity gave the ECB political breathing room to get more aggressive. The bank's pledge last summer to buy unlimited amounts of government bonds is largely responsible for taming Europe's financial crisis.

But austerity also inflicted severe economic pain in places like Greece, Ireland, Portugal, Spain and Italy. Over time — as the economy of the 17 European Union countries that use the euro descended into recession — evidence grew that slashing spending and raising taxes were less effective at reducing deficits than initially thought, and perhaps counter-productive.

Why? Because as economies shrink, so do tax revenues, making it harder to close budget gaps.

The latest eurozone recession, which began last year, is forecast to end in the second half of this year and was the main focus of Thursday's summit of European Union leaders in Brussels.

"We are all fully conscious of the debate, the mounting frustrations and even despair of people," said Herman Van Rompuy, president of the European Council, after the meeting ended.

"We also know there are no easy answers."

With unemployment at a record 11.9 percent and Europeans expressing their discontent at the polls and in the streets, many of the region's political and financial leaders are willing to postpone budget-cutting and deficit targets.

A few recent examples:

— EU officials have hinted Spain, France, Portugal and Greece might be allowed more time to reduce their deficits to within the limits specified by European Union rules.

— European finance ministers last week agreed in principle to grant Ireland and Portugal more time to repay bailout loans to other eurozone countries. While the countries cannot abandon deficit-reduction plans they agreed to in return for loans, it does allow them to cut budgets more slowly.

— ECB President Mario Draghi last week urged indebted governments to move beyond spending cuts and tax hikes and introduce labor reforms and other measures that would boost growth and reduce the "tragedy" of unemployment.

The rethinking of austerity gained momentum late last year after economists at the International Monetary Fund produced research that showed Europe's austerity policies had been far more damaging than policymakers thought.

It's hardly news to Ines Mendes of Lisbon, a 26-year-old flight attendant and mother of a 4-year-old. She said income tax hikes this year will cost her and her partner the equivalent of more than a month's pay each over the year, further squeezing her family budget.

"We could really use a break," Mendes said. "I don't know why they're doing this to us. It doesn't make sense, it's just killing our economy," she said of the EU's austerity demands imposed as part of the country's 2010 bailout.

Advocates of austerity haven't disappeared from the scene. Key leaders such as Germany's Chancellor Angela Merkel still espouse the virtues of balanced budgets.

"Budget consolidation, structural reforms and growth are not contradictions but require each other," Merkel told reporters after the summit of 27 EU countries on Thursday. "It is necessary to trim the deficits to promote growth and investment."

But there is a difference between the rhetoric and the actions these leaders endorse. Merkel's government agreed last year to the EU commission's recommendation to extend deficit-reduction deadlines for Portugal, Greece and Spain. And the EU commission is now judging countries based on their so-called structural deficit — or what the deficit would be excluding the effects of the recession. That gives countries more time to get their finances under control.

The new EU stance "doesn't mean countries don't need to do austerity. It means they only need to do the austerity that is needed to bring a country a balanced budget in structural terms. If a country is in a recession, this approach allows some deficit," says Berenberg analyst Schulz.

Across the eurozone, deficits as a proportion of economic output averaged 3.5 percent at the end of last year. That's down from 4.2 percent in 2011, and only slightly above the European Union target of 3 percent. However, among individual eurozone members, the picture is far less rosy — countries such as Spain and Greece are running deficits more than double the official limit.

A growing number of European countries appear headed in the direction of less austerity no matter what the euro region's leaders decide.

In last month's election in Italy, most voters supported parties that opposed the austerity policies of departing Prime Minister Mario Monti.

And last week, the finance minister of France, the eurozone's second-largest economy, said his country had ruled out more budget cuts despite a deficit of 4.6 percent of GDP.

"We refuse to add austerity to the recession," the minister, Pierre Moscovici, said.

The austerity rethink may come as cold comfort to millions of Europeans, especially those living in countries that received bailouts, such as Greece, Ireland and Portugal. These countries remain under pressure to keep spending levels down and continue unpopular tax hikes — even as they battle recession.

The Greek economy is in its sixth year of recession and the unemployment rate there has reached 27 percent. Portugal's economy contracted 3.2 percent last year — its severest annual downturn since 1975 — and its unemployment rate is at a record 17.2 percent.

In Portugal, hundreds of thousands of people recently turned out at to protest austerity measures being implemented to meet the conditions of its bailout. The opposition Socialist Party leader said: "Are we emerging from the crisis? No, we're worse off than we were before."

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AP writers Barry Hatton in Lisbon, Portugal, Juergen Baetz in Brussels, Elena Becatoros in Athens, Greece, and Sarah Di Lorenzo in Paris contributed to this report.