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France and Greece spur new era of uncertainty

A trader reacts at his desk in front of the DAX board at the Frankfurt stock exchange on Monday. Euro zone blue chips turned positive by mid-session, bouncing back from oversold territory after a knee-jerk reaction to French and German elections.

ALEX DOMANSKI/REUTERS

The resounding "No" from French and Greek voters has plunged the fragile euro zone back into uncertainty, promising to knock its German-led austerity drive at least somewhat off course and threatening the bailout designed to save Athens.

The defeat of the pro-austerity ranks in Sunday's elections will force German Chancellor Angela Merkel to redraw her tough approach to fixing the euro area's fiscal woes or risk becoming increasingly isolated, despite the fact her government holds the purse strings.

The latest political reversals bring to seven the number of European countries where disillusioned voters have tossed out leaders or governing parties in less than two years, as the sovereign debt crisis escalated and fiscally challenged governments began slashing budgets. In every case, planned or executed austerity has inflicted heavy damage on already weakened economies, triggering recessions and driving up unemployment across the region to a 15-year high.

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Not yet clear is the fate of the still-to-be-ratified European fiscal compact, championed by Ms. Merkel and requiring governments to balance their budgets or face stiff penalties.

French Socialist François Hollande based his victorious presidential campaign on promises to revamp the treaty and return the focus to economic growth. His sketchy plans include more spending to boost job creation and the postponement of deficit-cutting until the economy regains sounder footing. Mr. Hollande's rallying cry – an "end of imposing austerity everywhere, austerity that brought desperation to people throughout Europe" – resonated across the region.

"Immediate austerity, in recessionary economies, simply doesn't work – a point apparently better understood by many European voters than those they have elected," said David Kelly, chief market strategist at JPMorgan.

Ms. Merkel and her fellow disciplinarians cannot dismiss the anti-austerity drive lightly. Not only did the Chancellor lose her staunchest ally with the defeat of French President Nicolas Sarkozy but the outlook also darkened further in troubled Greece, where the two main centrist parties supporting the country's painful bailout conditions took a drubbing at the polls.

The euro slid Monday to its lowest level against other major currencies in more than three months. But reaction elsewhere in the markets was mild, largely because Mr. Hollande's victory had been widely expected and he is not regarded as a radical in European circles. Also, many investors had already written off insolvent Greece's chances of recovery any time soon.

Ms. Merkel has already declared that the fiscal deal reached in March will not be reopened. But she will be under intense pressure to adopt more pro-growth measures and show greater flexibility on the fiscal front.

Any concessions, though, would further tarnish her fading political star at home, where her conservative Christian Democrats lost another state election Sunday.

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In both France and Greece, electoral support swung to candidates promoting a return to growth based on public subsidies and rising debt and taxation, said Constantin Gurdgiev, a finance lecturer at Trinity College in Dublin. "This will have long-lasting implications for the euro area."

The markets, he predicts, "will begin pricing in the risk of the euro area returning to the traditional debt-and-taxes model of development. This time around, after the protracted fiasco of dealing with the Greek crisis, and after committing Portugal, Ireland, Spain and Italy to a debt jail, European leaders will encounter even less trust from the financial markets."

But some analysts say refocusing on growth might be a good idea. What Europe needs now is some "enlightened macroeconomic approach," while easing up on the austerity pedal, Mr. Kelly said.

That option may not be open to Greece, which has already agreed to draconian cuts to keep billions of euros in bailout money flowing.

"I expect lots of dust to remain in the air for the foreseeable future," said Nicolas Véron, a visiting fellow at the Peterson Institute for International Economics in Washington. "We seem to have a situation of fairly permanent political instability hardwired into the Greek landscape."

Whether that becomes a concern to the rest of the euro zone "is too early to tell, because the Greek public doesn't want an exit from the euro. So it can be expected that whatever shaky, transitional government is in power will do what it takes to keep the show on the road. But it's not going to be smooth and there's going to be a lot of drama, which after all is a Greek word."

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