By Paul Taylor
PARIS (Reuters) - With the euro zone bond market back to irrational exuberance and economic growth returning slowly if unevenly, politics rather than economics now poses the biggest threat to the long-term endurance of Europe's single currency.
Widespread anti-EU protest votes in last month's European Parliament elections will make it harder for many governments to pursue deficit-cutting and structural economic reforms or to deepen the integration of the 18-nation euro area.
Public resistance in Germany, Europe's biggest economy, may make it impossible for the European Central Bank to go beyond last week's monetary easing measures to more radical U.S.-style asset purchases if low inflation persists or worsens.
Berlin is balking at using its own healthy fiscal position to invest more in infrastructure or spur domestic demand with tax cuts that could help balance Europe's economic adjustment.
European Union leaders and the ECB have done enough to restore market confidence for now by equipping the euro zone with a financial rescue fund, stricter fiscal discipline, a single banking supervisor and a de facto lender of last resort.
But the political will to complete economic and monetary union looks ever weaker, especially if it requires winning public approval for changes to the EU's governing treaties.
In a book published before the elections(*), French economist Jean Pisani-Ferry argued that Europe's leaders were reluctant to give any more power to Brussels and sought to avoid controversy over further European integration.
"Fighting the euro crisis has already proved divisive domestically. The less they take initiatives, the less they risk political problems at home," he wrote.
The surge in support for Eurosceptic and anti-establishment parties in the May 25 vote can only reinforce that inertia now that the acute need for action has passed.
Even critics who predicted the euro zone could break up, such as U.S. economist Nouriel Roubini, acknowledge that much has improved in the last two years.
"Certainly many things in the euro zone are moving in the right direction," he told a conference of the Maurice Allais Foundation in Paris, listing more sustainable fiscal policies, reforms of labor markets, pension and welfare systems and improved cost competitiveness in several countries.
ECONOMY ON MEND
Countries that received bailouts have regained full access to market funding, except Greece and Cyprus, and even Athens has issued a first five-year bond.
As investors pile back into Europe, yields on Spanish 10-year government bonds are now roughly level with their U.S. and British counterparts, three years after Madrid needed a 43 billion euro ($58.7 billion) EU bailout to restructure its shattered banks.
Four of the assisted countries - Greece, Ireland, Portugal and Spain - were among the top five performers for improving their competitiveness in the latest "Going for Growth" report of the Organisation for Economic Coooperation and Development.
All have substantially reduced unit labor costs, eliminated big current account deficits, shrunk the public sector payroll and made progress towards balancing their budgets.
The giant black spot is unemployment - still above 25 percent in Spain and Greece and more than half of all young people.
All are also emerging from the crisis with much heavier debt burdens, although the weight of debt service is lightened by long delays before they have to repay loans to the EU rescue fund, likely to be extended still further for Greece.
But optimistic EU officials say the euro zone periphery will be its most dynamic region in the coming years, comparing it with the success of bitter IMF medicine in South Korea and Indonesia after Asia's financial crisis in the 1990s.
Many economists doubt that, however. Pisani-Ferry, now head of the French government's policy planning unit, says the de-industrialization of southern Europe may be irreversible.
LE PEN ET AL
The focus of concern is now shifting to France and Italy, the euro zone's second- and third-largest economies, which did not require bailouts and have implemented fewer reforms.
Italian Prime Minister Matteo Renzi bucked the trend in the European vote, winning a strong mandate to pursue reforms of the political system and labor markets.
But given Rome's endemic political instability, the enduring blocking power of vested interests and the weakness of its legal system, he still faces daunting obstacles.
The biggest challenge may be France, where the EU election victory of Marine Le Pen's far right National Front has weakened President Francois Hollande's Socialist government just as it is finally set to ease the tax and regulatory burden on business.
Hollande's 81 percent disapproval rating and back-to-back defeats in municipal and European elections may drain him of the authority to implement reforms vital to revive investment and job creation in France.
Protectionist pressure from Le Pen's anti-EU nationalists and the left, including Socialist party rebels, may push Paris to obstruct EU-U.S. free trade negotiations.
Electoral gains for hard left anti-austerity parties in Greece and to a lesser extent Spain have raised pressure for a let-up in public spending cuts and unpopular economic reforms.
"The social and political backlash against austerity and reform could become overwhelming," Roubini warned.
Renzi is hoping to use his political honeymoon to engineer a new European bargain in which the budget deficit rules are adapted to allow more space for public investment in countries that are implementing EU-recommended structural reforms.
But even if EU leaders are able to agree to tilt their economic policy mix some way from austerity towards expansion, the institutional changes needed to strengthen Europe's monetary union durably seem politically harder than ever.
(* The Euro Crisis and its Aftermath, Oxford University Press)
(Writing by Paul Taylor; Editing by Hugh Lawson)