Political upheaval, deteriorating economic conditions and mounting public anger threaten to bury Europe's unified austerity plan.
Greece and other peripheral economies in the euro zone have already been battered by infighting, prolonged slumps and social unrest after crumbling under unsustainable debt loads. But now fissures are spreading to healthier parts of Europe, with the potential to undo a German-led scheme aimed at stemming the deepening financial crisis and buying enough time for long-range reforms.
The end result could be the death of the European Union's vaunted fiscal compact, under which governments must pass laws requiring balanced budgets and suffer automatic penalties if they breach the standard. The failure to adopt tougher fiscal discipline would, in turn, renew doubts about Germany's willingness to continue shoring up weaker euro-zone countries and cast new doubt on the survival of the single monetary system itself.
The latest political developments – an expected loss for French President Nicolas Sarkozy in the first round of voting in the presidential election, the unexpected collapse of the Dutch ruling coalition over budget cuts and a looming no-confidence vote for the Czech government, also over austerity measures – combined with fresh signals of economic erosion to cut a swath of destruction Monday through stock, commodity and currency markets.
Selling was widespread. In Europe, stocks hit a three-month low, led downward by the financial sector. Euro-zone banks fell nearly 4 per cent to lows reached last November, before the European Central Bank intervened with a massive injection of cheap long-term funding to shore up crumbling balance sheets. Canadian stocks lost 1.3 per cent as energy and mining shares retreated. Investors again flocked to the safety of U.S. Treasuries, pushing 10-year yields to their lowest level since late February.
Political casualties are mounting quickly.
Mr. Sarkozy, a staunch ally of German Chancellor Angela Merkel and her tough fiscal prescriptions for the euro zone, lost the first round of voting Sunday in his bid for re-election. Polls show him losing the runoff next month to Socialist rival François Hollande, whose rallying cry is an "end of imposing austerity everywhere, austerity that brought desperation to people throughout Europe."
The pummelling of the unpopular French President was widely forecast. What caught analysts and the markets by surprise was the Dutch deadlock. The Netherlands has long been a vocal proponent of tougher fiscal discipline, although its own deficit is forecast to be 4.6 per cent this year, well above the EU's current 3-per-cent target. France is also offside, with a projected shortfall this year of 4.4 per cent.
"It should not be excluded that we could see a repetition of the 2002-2004 episode when the fiscal rules were changed after the biggest euro-zone countries had breached them," said Carsten Brzeski, a senior economist with ING in Brussels.
With their current fiscal woes and an increasingly inhospitable bond market, the French would be unlikely to change direction much under a Socialist government, despite Mr. Hollande's campaign promises, analysts say. And the Dutch political crisis is not necessarily a negative for the euro zone.
"The current government was not distinguished, by Dutch standards, for its euro enthusiasm, to say the least," said Nicolas Véron, a visiting fellow at the Peterson Institute for International Economics in Washington. Its replacement "could turn out to be more constructive, rather than less."
The euro-zone's outlook was further clouded by worsening economic signals. German manufacturing, one of the euro zone's few bright spots, contracted at its fastest clip in almost three years. Spain formally slid back into recession, as the economy shrank 0.4 per cent in the first quarter, slightly worse than its decline of 0.3 per cent in the final quarter of 2011. And the latest purchasing managers' survey revealed more euro-zone headaches in both manufacturing and services. A Markit Economics composite index derived from the survey slid to 47.4 in April from 49.1 in March. Any readings below 50 are harbingers of contraction.
Public anger over enforced austerity remains a potent political threat. Greece faces an election May 6, the outcome of which remains in considerable doubt. As many as 10 parties could win parliamentary seats, some of them with extreme views on the left and right of the political spectrum.
And the plainly unpopular European fiscal plan will face its first direct test May 31, when Ireland puts ratification to a public referendum. Britain and the Czech Republic are the only countries in the 27-member EU that have not agreed to implement it or put it to a vote.