European finance ministers opened the way for looser budgetpolicies after a backlash against austerity thrust Italy intopolitical limbo and shattered months of relative stability inEuropean markets.

Italy's deadlocked election, France's refusal to make deeperbudget cuts and protests against the shrinking of the welfare stateacross southern Europe escalated the rebellion against theGerman-led prescription for fighting the debt crisis.

Economic strains “may also justify in a certain number of casesreviewing deadlines for the correction of excessive deficits,”European Union Economic and Monetary Commissioner Olli Rehn toldreporters late yesterday after a meeting of euro-area financeministers in Brussels.

The euro-zone economy will shrink 0.3 percent in 2013, makingfor the first annual back-to-back contraction since the currency'sbirth in 1999, the European Commission forecast last month. Thecurrency-bloc prediction masked a widening north-south divide, withgrowth in countries like Germany, Finland, Belgium and Luxembourgset against dwindling output in Italy, Greece, Spain andPortugal.

France is straddling the middle, set to eke out a 0.1 percentexpansion after the economy stagnated in 2012, according to thecommission. Deeper budget cuts are out of the question, FrenchFinance Minister Pierre Moscovici said.

“We do not want to add austerity to recession,” Moscovici said.“If our rules are intelligent, they are also flexible. We have tofind the right rhythm and the right balance without weakening thelittle growth left.”

France is counting on estimates that it has made sufficientreductions in the “structural” deficit — a figure that factors outthe effect of the economic cycle — to escape a European order tocut more.

French President Francois Hollande became a spokesman forsouthern European opposition to belt-tightening last year afterousting Nicolas Sarkozy, who toed German Chancellor Angela Merkel'santi-crisis line.

“The cure is not working, and there is no hope that it will —that is, without being worse than the disease,” Joseph E. Stiglitz,the Nobel Prize-winning Columbia University economist, said in aposting on Project Syndicate. “Germany has consistently rejectedevery policy that would provide a long-term solution. The Germans,it seems, will do everything except what is needed.”

Financial Crisis

Italy's political stalemate — with a quarter of the vote in theFeb. 24-25 election going to a protest movement headed by BeppeGrillo, a former comedian — dramatized the stakes in therecession-hit European economy that has yet to shake off thefinancial crisis.

The biggest vote-getter in the lower house of parliament, PierLuigi Bersani of the Democratic Party, is trying to form agovernment by outmaneuvering Grillo's blocking minority in theupper house. A second election — analogous to Greece in 2012 —figured as a possibility.

Italian bonds rebounded from a two-day slide today. Ten-yearItalian yields fell 12 basis points to 4.76 percent, paring theextra borrowing costs over German levels to 331 basis points. Thespread, an indication of the perceived risk of Italian investments,remained above its pre-election level of 288 basis points

Italians revolted against the budget cuts spearheaded bytechnocratic Prime Minister Mario Monti, even though no one inEurope called for additional savings. The apolitical Monti, tappedto head a unity government in November 2011, picked up 10 percentof the vote.

Germany's Merkel indicated that she is sensitive to criticismsthat budget cutting has been overdone.

“We've done quite a bit to consolidate budgets, but we alwayshave this discussion about growth, and don't quite have the answersfor where the growth should come from,” Merkel said late yesterdayat the CeBIT technology fair in Hanover.

Messages from the Brussels-based commission have catered to twoaudiences, with pro-austerity rhetoric aimed at northern Europecontrasting with policy decisions to ease the strains on theunemployment-plagued south.

With the northern public in mind, Rehn said it is wrong tocharacterize the more flexible approach as “leniency.” He said thebudget rulebook “is not stupid, but it focuses on the structuralsustainability of public finances.”

The commission last year recommended — and governments includingGermany endorsed — extensions of deficit-reduction deadlines forPortugal, Greece and Spain. It is considering giving France extratime to get its deficit down to 3 percent of gross domesticproduct, the euro-area limit. Portugal and Spain are also clamoringfor additional relief.

“Merkel and her allies have exhibited more flexibility towardthe troubled countries of southern Europe than is oftenacknowledged,” Jacob Funk Kirkegaard, a senior fellow at thePeterson Institute for International Economics in Washington, saidin a blog post yesterday. “The euro area has considerable leeway inits new fiscal surveillance framework.”

Bloomberg News

Copyright 2018 Bloomberg. All rightsreserved. This material may not be published, broadcast, rewritten,or redistributed.