The rating agency said Monday in its European sovereign outlook report that the key to maintaining high ratings and, therefore, low-cost access to debt markets is a careful balance between supporting economic growth and making tough decisions to cut government spending.

But while Moody’s said government slimdowns are necessary, it warned that “given the magnitude of the fiscal challenge and the need to sustain tight fiscal policy for several years, we conclude that the risks to economic growth are clearly to the downside.” It called dealing with weak growth Europe’s biggest challenge. 

The rating agency said government cutbacks will slash consumption spending across Europe in coming years, as belt-tightening takes place on an unprecedented scale.

“Never before in modern history have so many countries attempted to undertake such large fiscal adjustments simultaneously,” Moody’s said. “In the next six-nine months at least, the impact on growth is likely to be negative.”

The comments come at a time when investors, ignoring those risks, have rushed headlong into the bonds issued by big governments. The bond mania has slashed borrowing costs even in fiscally challenged states such as Spain.

Moody’s said in June it would review Spain’s rating for a possible downgrade, but since then the yield on 10-year Spanish bonds has dropped to 4.08% from 4.65%.

The rating agency argued that improving governments’ budget position now could actually help to revive growth over the next few years, by increasing domestic economic confidence. This is a line European leaders have been taking since June, at a time when U.S. policymakers have been warning about the dangers of tightening fiscal policy too fast.

The key to a successful response, Moody’s said, is to pair lasting spending cuts with reforms in labor markets, tax policy and entitlements such as health care and retirement programs. It said a look at history shows large adjustments tend to work better than smaller ones, and that cutting spending impresses markets more than raising taxes.

We will closely monitor whether the adjustment paths taken by governments have the potential to be growth-enhancing, thereby facilitating the social acceptance of the substantial fiscal pain that is to come and increasing the likelihood that the fiscal adjustment will be durable and successful. The ratings of countries that follow this path are more likely to remain at their currently high levels. Recent actions by several Eurozone governments are encouraging, as they reflect a stronger focus on expenditure cuts, compared with fiscal actions within 2010 budgets that had been centered more on the “low hanging fruit” of tax rises and cuts in public investment.

Moody’s also noted that the massive amounts of debt on consumer and government balance sheets will complicate any recovery, making slow growth “the greatest challenge facing Europe” in coming years. It hinted that in spite of all the press the fiscal tightening question has been getting, the delveraging threat is the one that is not to be underestimated. 

Credit grew very quickly in most countries during 2002-07, and banks, companies and households are now beginning to deleverage and pay down their debt, either willingly or out of necessity. History tells us that deleveraging episodes following financial crises are usually particularly difficult, causing economic stagnation and weakening government revenues. In Japan, for example, government revenues in nominal terms are still below the levels they achieved 20 years ago.