Europe's backlash against austerity gained momentum, in a challenge to German Chancellor Angela Merkel's budget-cutting prescriptions for resolving the debt crisis.

French President Nicolas Sarkozy lost the first round of his re-election bid and a revolt against extra spending cuts in the traditionally budget-conscious Netherlands propelled Prime Minister Mark Rutte's coalition toward an early breakup.

Together with anti-austerity rumblings in a campaign for elections in Greece, the shift in grass-roots sentiment at the heart of Europe generated fresh doubts about the German-driven strategy for getting to grips with the two-year-old crisis.

“We have organized the track of discipline, that's very good and we have to continue on that, but we need desperately also to organize the second track, the track of growth, solidarity, investment,” former Belgian Prime Minister Guy Verhofstadt, now a member of the European Parliament, said on Bloomberg Television's “The Pulse.”

The euro fell as bond investors moved money into Germany and out of the Netherlands, Belgium, Spain and Italy amid concern that a consensus over the crisis response is fraying. The yield on Germany's five-year bond fell to a euro-era low of 0.61 percent while the premium that investors demand to hold Dutch bonds over bunds rose to the highest since 2009.

Political tensions coincided with a report of a greater-than-expected decline in services and factory output in April, equipping opponents of austerity with evidence that budget-cutting zeal may cast the 17-nation euro region into recession.

Northern European advocates of tight fiscal policies pointed to a separate report from the European statistics office showing that the aggregate debt of euro governments reached 8.2 trillion euros ($11 trillion) in 2011, the highest in the currency's 13-year history.

Merkel, who has dominated Europe's crisis response, said debt reduction is the best route to economic health.

“Solid budget management is a factor for producing growth, but of course not the only one,” Merkel said yesterday at the Hanover trade fair, a showcase for high-tech products. “We're still in the process of overcoming this crisis.”

While that has pushed down German borrowing costs, other European countries are struggling to convince investors that austerity is the best route to political stability and financial health. Ten-year bond yields rose 3 basis points to 5.94 percent in Spain today and 6 basis points to 2.37 percent in the Netherlands.

Sarkozy Trapped

The politician caught in the middle is Sarkozy, who sought to balance the German anti-deficit line with pro-growth policies, and delivered on neither count. France was stripped of its AAA credit rating by Standard & Poor's in January and had 9.8 percent unemployment in the fourth quarter.

While French bonds have since rallied, the risk premium on 10-year debt at one point last year rose to the highest since Francois Mitterrand was president in 1990. The spread over German bunds is now at 145 basis points compared with 190 in November.

Voters punished Sarkozy yesterday, making him the first incumbent in the 54-year history of France's Fifth Republic to come in second in a presidential primary. He now faces an uphill climb in a May 6 runoff against yesterday's front-runner, Socialist rival Francois Hollande.

Hollande pressed the advantage today, telling a rally in Quimper on the Brittany coast that a Socialist victory would “be the end of imposing austerity everywhere, austerity that brought desperation to people throughout Europe.”

Hollande has promised to renegotiate a deficit-reduction accord that Merkel pitched to German voters as proof that Europe has embraced fiscal rigor. The yet-unratified accord also helped convince the European Central Bank of governments' determination to stamp out debt.

In the final days of the campaign, Sarkozy's temptation is to reach out to backers of Marine Le Pen's anti-immigrant National Front, which tallied 17.9 percent in the first round, its best result ever. Such a tilt would distance Sarkozy from the European mainstream if re-elected.

National Front

“What would the National Front mean: no euro, no Europe,” Luxembourg Foreign Minister Jean Asselborn, a Socialist, told reporters in Luxembourg today. “If I were president of the republic, I'd be asking myself why one in five French voted for the National Front.”

A party that rejects immigration and bailouts for debt-ridden countries flexed its muscles in the Netherlands, one of four remaining AAA states in the euro zone and a traditional enthusiast for fiscal and wage restraint.

Geert Wilders, head of the Freedom Party, balked at social security cuts over the weekend, removing support for Rutte's minority government. Rutte's Cabinet offered to quit today, putting early elections on the horizon. Queen Beatrix asked the Cabinet to stay as a caretaker in the meantime.

Credit-default swaps on Dutch bonds jumped 11.5 basis points to a five-month high of 130 at 3:20 p.m. in London, according to data compiled by Bloomberg.

The chances of a Dutch political compromise “do not look very high,” Riccardo Barbieri, chief European economist at Mizuho International Plc in London, said in a note to investors. “Germany looks increasingly isolated within the euro zone due to its low budget deficit and stringent discipline-enforcing mechanisms.”

The Netherlands posted a deficit of 4.7 percent of gross domestic product in 2011, the third year over the euro limit of 3 percent, today's official EU data showed. Rutte needs to cut an extra 9.5 billion euros to meet the target by 2013. The economy is likely to shrink 0.9 percent this year, the EU forecast on Feb. 23.

The rebellion against austerity among longstanding German allies sharpens the focus on elections next month in Greece, the epicenter of the debt crisis. The Greek poll, also on May 6, looms as a referendum on the budget cuts demanded of Greece in exchange for bailout loans now worth 240 billion euros.

Antonis Samaras, head of the New Democracy party, yesterday promised lower taxes and an end to the across-the-board pension and wage cuts that have triggered the steepest economic slump since the end of World War II. Budget savings will mainly come through fighting waste, he said.

Samaras's party is on track to win between 104 and 112 seats in parliament, leaving it short of an outright majority to govern, a poll by Public Issue SA showed. As many as 10 parties may enter the parliament, the poll showed.

“What you've got, look right across the EU, is an anti-incumbency move,” said Richard Whitman, an associate fellow at Chatham House in London. “Where publics have chance to express their dissatisfaction with incumbents, they're giving incumbents the kicking.”

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Europe Sees Austerity Backlash

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