Is the Age of Austerity Over?

Europe wobbled a bit this week from the delicate balance-beam act it has been walking. Since the beginning of the debt crisis, the unwritten deal has been that Germany (in concert with the European Central Bank and the International Monetary Fund) was willing to use its strength to backstop failing countries in return for the adoption of aggressive austerity measures and agreements for further structural reforms.

There has been some pushback against this model (notably from Greece), and Germany isn't willing to go as far as issuing jointly secured eurobonds, but for the most part the agreement has held up. Some political rumblings this week, however, are a reminder that not everyone is happy with the compact. The crisis could very well flare up again as Europe adjusts to its new political reality.

Political Problems of Paring Debt
One expected, and one unexpected, political news story drove the conversation about Europe during the last few days. The first was in France. As expected, incumbent conservative president Nicolas Sarkozy trailed socialist candidate Francois Hollande in the first round of the French presidential elections. Because neither man reached a 50% threshold, they will go head-to-head in a run-off election May 6 that Hollande is favored to win.

Of course there are plenty of idiosyncratic and country-specific reasons that Sarkozy is falling behind. But pan-European concerns have been one of the major issues of the campaign. Hollande is critical of what he sees as overly aggressive German austerity and wants to increase spending in France on education and pay for it with higher taxes on the wealthy and businesses. He sees a need to bring down France's budget deficit, but he would like to do so in a different way than Germans desire and without some of the structural labor market reforms that other EU countries are currently implementing. Sarkozy on the other hand has stood by the German plans to save the eurozone. The vote against Sarkozy can be read as the French people's rejections of that plan. 

The unexpected turmoil was when the Dutch government fell this week. A right-wing party left the government over a disagreement on how to bring down the country's budget deficit to within EU guidelines, resulting in the resignation of Dutch prime minister Mark Rutte and his cabinet. A fresh election is scheduled for September, and though it is too early to tell exactly who the Dutch will vote for, it is quite possible they will also reject the current plans for more austerity. The collapse of the government of what was previously one of Europe's most stable economies is striking and has added a fresh layer of uncertainty.

So why are the French, the Dutch, and other European citizens starting to chafe at the idea of even more cuts? Although there are myriad historical and cultural reasons for the backlash, a big one has to be growth or that lack thereof. Look at the United States for a moment. If you stop a few people on the street and ask them what they think of the economy, you aren't going to get a tremendous number of positive responses. People might say that it is better than it was a couple of years ago, but most would be surprised to hear we have reclaimed the prerecession gross domestic product level in real terms.

Europe is still far from these levels and is beginning to see its GDP slip again. This chart by Reuters' Scott Barber underscores how far behind Europe has fallen. If austerity has brought nothing but slower growth so far, many voters are skeptical of the claim that this medicine will be good for them in the long run. Imagine the popular unrest in the U.S. if growth were even substantially slower than it is today! European voters aren't going to be happy until economic futures seem more secure, and it seems they want to see that happen with looser fiscal policy and not deep austerity.

Expect the Unexpected
So will these new voter preferences translate into new polices for dealing with the debt crisis? At first, the changes are likely to be fairly minor. If Hollande does indeed win the election next weekend, the tight German-Franco alliance will likely be put under stress, but it won't be beyond repair. France will almost certainly push for more fiscal flexibility, and Germany could very well ease up on some of its demands.

But the real test will be when the next unexpected flare-up occurs. If Spain were suddenly to lose the market's faith and need a bailout, would a new French government and Germany be able to agree on terms? If they did agree on less stringent austerity measures, would the IMF and ECB go along for the ride? Would bond markets accept the less strenuous terms as credible? Is not implementing structural reforms now just kicking the can down the road and leaving countries with uncompetitive economies?

In short, no one knows the answer to these questions. We just don't know what the new equilibrium will look like, either. The only thing we do know is that the rise of antiausterity forces in European politics has yet again increased the level of uncertainty in Europe. The less certain everyone is about the rules of the game, the longer it is going to take for the continent to pull itself out of this funk and return to growth again. A permanently limping Europe will do nothing to help increase growth in the U.S. or help U.S.-based investors. Expect more waves and surprises as Europe seeks its political footing.