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Europe’s fiscal austerity policies are the key issue in elections taking place today (May 6th) in France and Greece. They are happening in the context of a growing backlash across Europe against efforts to slash deficits, according to QNB Group analysis.

Austerity policies—reducing government spending and raising taxes—were developed in response to Europe’s sovereign debt crisis and enshrined in a fiscal compact signed by 25 EU states (all except the UK and Czech Republic), which is awaiting ratification. The compact requires countries to implement legally-binding balanced budget laws, or face fines, and to reduce their public debt levels to 60% of GDP over 20 years.

Following agreement on the compact, the Eurozone received a boost over the recent months when the European Central Bank provided around US$1trn in two allotments of three-year financing to banks at 1% interest. This temporarily reduced concerns about liquidity in the European banking sector and contributed to a fall in government bond yields and a rally in equity markets.

However, a raft of bad economic data, including poor first quarter GDP figures and rising unemployment numbers in some countries, has begun to turn the sentiment sour. Moreover, as fears of sovereign debt defaults and an imminent breakup in the Eurozone have receded, the political impetus for deficit reduction has diminished. Therefore, the political debate has shifted increasingly to the pain caused by the austerity policies and structural reforms.

Critics of austerity say that it is preventing Europe’s economy from recovering from recession, and could thereby undermine the deficit reduction goals themselves. Amongst these critics is Joseph Stiglitz, a former World Bank Chief Economist, who warned recently that the European policies are dangerous because there is no precedent for a successful austerity programs in any large country.

On the same day, Standard & Poors cut its sovereign rating for Spain by two notches to BBB+, following a downwards revision in its forecast for Spanish GDP this year, from mild growth to a 1.5% contraction. It warned that fiscal austerity would exacerbate the risks to Spanish growth over the medium term.

Spain is facing particularly serious difficulties in reviving its economy, which has just slipped back into recession and posed a deficit of 8.5% of GDP in 2011. In addition, new data shows that its unemployment rate has reached a record 24.4%, and youth unemployment is more than double that level. In this context, the yield on Spanish debt (and also Italian debt) seems to be drifting back towards the 6% level that is seen as being unsustainable.

In the last week of April, the governments in Romania and the Netherlands both collapsed in no-confidence votes. This happened as members of the ruling coalitions defected in opposition to austerity measures that are unpopular with the public.

All eyes are now on the elections today. Greece has undergone by far the most extreme austerity over the last few years. It has sought to reform a bloated public sector and meet deficit reduction targets, upon which bailout funding, needed to refinance its debt, has been conditional. The country has faced waves of strikes in opposition to these policies.

Some opinion polls suggest that rising support for parties opposed to austerity may prevent a coalition of the two main parties from forming a parliamentary majority. These parties were formerly staunch opponents, but have now been forced into alliance for the sake of the country’s EU bailout, which requires the implementation of austerity policies. Political turmoil in Greece could undermine the bailout and revive fears about the country exiting the euro.

Meanwhile in France, Europe’s second largest economy, polls suggest that the socialist candidate, François Hollande, will unseat Nicolas Sarkozy as president. Mr Hollande has called for renegotiation of the European fiscal compact to add elements aimed at promoting growth and job creation, such as jointly-backed bonds to fund infrastructure projects. Although he is not planning on completely reversing austerity, his is spearheading the shift in European thinking towards policies designed to stimulate growth in the short-term.

Mr Hollande’s proposal to revise the compact is not being received favourably by countries that spearheaded the agreement. However the EU policy community appears to be open to implementing some of his growth suggestions through different channels.

Mario Draghi, the president of the European Central Bank, has spoken of the need for a separate growth compact and Herman Van Rompuy, the president of the European Council, has floated the idea of an emergency heads of government meeting to discuss growth strategies. This indicates a shift in European thinking from austerity to more growth-focused policies.

In its recent World Economic Outlook, the IMF forecast that the EU economy will be flat in 2012, with 3.3% growth in Germany offset by contractions in countries such as Italy, Spain and Greece. Growth will remain well below pre-crisis levels in subsequent years. Meanwhile, the IMF forecasts a fiscal deficit of 3.8% of GDP for the year—all countries will be in the red, ranging from 0.8% for Germany to 8.5% for Ireland.

The coming weeks are likely to be turbulent economically for Europe, whatever the outcomes of the Greek and French elections. However, QNB Group notes that there is a growing recognition that even if austerity is unavoidable, more efforts are needed to soften its edges and promote growth. It will be a difficult balancing act.

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