.
ANALYSIS
Less than a month after European leaders unveiled a "comprehensive package" they said would fix the euro zone, their anti-crisis strategy is fraying and may be in need of a radical rethink.
Rising public anger in northern Europe at a series of taxpayer funded bailouts is sending tremors through the political landscape, boosting anti-euro parties such as the True Finns in Finland and sparking open policy rows in European paymaster Germany.
The emerging consensus in the markets that Greece will have to restructure its 327 bln euros in sovereign debt, in spite of the European Union/International Monetary Fund rescue it secured one year ago, has made Europe's promise to delay any private sector pain until 2013 look increasingly untenable.
The flaws in the euro zone's strategy are being exposed just as it negotiates what is expected to be an 80 bln euro aid deal for Portugal, whose own politicians have been arguing for months that the Greek and Irish bailout model is a failure.
This comes against a backdrop of deepening recession or unexpectedly weak growth in Europe's austerity-hit periphery, which is reinforcing doubts about whether these countries can stage the strong recoveries needed to cut their debt and win back investors once bailout funds run out.
As resentment of bailouts rises in the north, opposition to further austerity is growing in the south, creating a dangerous dynamic that some economists and political experts believe could force changes to Europe's strategy within a matter of months.
"We are at a juncture where the gravity of the economic fundamentals and public opposition to further bailouts may pull the politicians in a new direction," said Steen Jakobsen, chief economist at Saxo Bank.
"As long as their strategy is credible they will continue down the same path. But now it looks like we are close to a turning point. The current path no longer looks as credible as it once did."
DEAUVILLE DILEMMA
There are some signs that would appear to suggest Europe's strategy is working.
Despite an escalation of the euro zone crisis over the past few weeks which has pushed bond yields on Europe's periphery to record highs, the euro has risen to 16-month highs against the dollar.
But that has been driven more by expectations of further interest rate hikes from the European Central Bank than any sense that Europe is closer to solving its crisis.
The bloc's biggest conundrum is Greece, a country whose sovereign debt levels are forecast to rise to 160% of annual output over the coming years, on a par with Zimbabwe.
Private economists have been saying for months that this debt mountain is unsustainable, but some policymakers in Europe appear only now to be waking up to that fact.
The immediate dilemma they face is that the blueprint for their future financial safety net, the European Stability Mechanism (ESM), which is due to be established in mid-2013, does not give them the flexibility they need to deal swiftly and cleanly with the Greek debt problem.
The root of the problem can be traced back to a deal on the ESM struck in Deauville, France last October between German Chancellor Angela Merkel and French President Nicolas Sarkozy.
That deal foresaw private debt holders sharing in the pain of future debt restructurings. But as markets grew nervous in the weeks that followed, Germany backtracked and pushed back the threat of "haircuts" until 2013. That move now looks misguided.
WILD CARD
By postponing the real pain until 2013, the bloc has guaranteed that the threat of a tough restructuring will hang over it like a dark cloud for at least two more years, hurting not only market sentiment towards Greece but also Ireland, Portugal, Spain and possibly others.
As Greece's outstanding bonds mature, the EU and the IMF are pumping money into Greece by extending it emergency loans under the country's 110 bln euro bailout deal. So when 2013 rolls around, European authorities and the IMF are expected to hold more than half of Greece's total debt. If they then restructured Greek debt to return the country to a sustainable debt path, they would have to impose an aggressive haircut on themselves.
And even after that, Greece might still need support from other European governments, probably for years. The only obvious way to avert this explosive scenario is for Europe to renege on its pledge and hit investors in Greek bonds now, accepting the risk of deterring investment in other countries' bonds.
"The easiest way out would be to do the restructuring soon," said Charles Grant, head of the Centre for European Reform in London. "Hit the private creditors and recapitalise the banks. It may still happen."
The wild card remains public opinion and politics. In Germany, the junior partner in Merkel's coalition is vowing to defend parliament's right to veto ESM payments. Some lawmakers in the Bundestag want to block approval of the creation of the ESM altogether.
The new mechanism is also running into trouble in Slovakia. In Finland, the True Finns party has suggested that a meeting of finance ministers in mid-May to approve a bailout for Portugal could end up producing an "entirely different" solution.
Europe has seen off political challenges to bailouts in the past; when Slovakia balked at approving plans for the bloc's current financial safety net last year, bigger countries pressured it into line. But in the current climate, such pressure may not be so forthcoming.
There are no obvious alternatives to a bailout for Portugal, which has said it will run out of funding by June if no bailout is agreed.
But the message that the True Finns are sending out — that taxpayer-funded bailouts are proving costly failures — could begin to resonate among European leaders at some point.
In Germany there is an expression "Augen zu und durch", which loosely translated means: "Close your eyes, continue down your path and hope for the best". At some point soon, this approach may no longer be an option.
