By Paul Taylor
BRUSSELS (Reuters) - European policymakers should be asking themselves "who lost Italy" after a grassroots revolt against austerity, unemployment and the political elite caused an electoral earthquake in the euro zone's number three economy.
Instead, most are insisting that their policy mix to fight the currency area's debt crisis is right, even though the latest EU forecasts have pushed any prospect of meaningful economic recovery in southern Europe back into the middle distance.
A surge in support for anti-euro populist Beppe Grillo and the surprise resurrection of former Prime Minister Silvio Berlusconi on an anti-austerity platform in last week's election have plunged Rome into political deadlock.
Italy, which had been governed by respected technocrat Mario Monti for 15 months since Berlusconi's last government fell, is far from the worst affected by the three-year-old debt crisis.
Unemployment there stands at 11.7 percent, less than half the rate of Greece and Spain, where one of every two young people is without a job.
If a milder recession and less severe spending cuts and tax rises can cause such a social and electoral revolt in Italy, the risks of an explosion in Greece and Spain ought to be greater.
Yet the official reaction from Brussels and Frankfurt is to act as if nothing, or almost nothing, had happened.
"The crisis is not yet over and efforts must not be relaxed," European Commission President Jose Manuel Barroso said in a joint statement with Monti two days after the election.
At a Reuters Summit on the future of the euro zone, Barroso appealed to European leaders to stay the course and "not give in to populism". Despite the bleak growth forecasts, structural reforms were starting to bear fruit, he said.
Barroso reeled off figures showing current account deficits in Portugal, Spain, Italy and Greece were shrinking and Ireland was back in surplus. Exports from Spain and Portugal were rising and the labor competitiveness gap between northern and southern Europe was narrowing.
Those numbers have a flipside. Payments imbalances are down mostly because those countries' imports have shrunk due to sinking demand. The labor cost gap has declined largely due to mass layoffs in southern states rather than productivity gains.
Exports account for less than 20 percent of the Iberian countries' output, less than half Germany's ratio and too little to offer a fast track to recovery.
While the European Central Bank removed the danger of a financial meltdown of the euro zone with its bond-buying plan, there is now a growing risk of a social crisis that could lead to one or more southern countries leaving the currency area.
"I absolutely think it can get a lot worse," said Clemens Fuest, the incoming chief of Germany's respected ZEW economic research institute.
"There is really the current plausible scenario for a break-up of the currency union. It may very well be that in these countries at some point the population will say 'we don't believe things will get better'," he told the Reuters Summit.
The degree of despair would have to be high to risk leaving the euro area, "but if things continue, if unemployment goes up to 30 percent... in Spain, there certainly is a danger that might happen".
Zsolt Darvas of the Bruegel think-tank in Brussels said southern European countries were trapped in a downward spiral of economic contraction and rising debt for an unknown duration but had no alternative to fiscal consolidation.
The only way out was to alter Europe's fiscal policy mix by stimulating demand in northern Europe, notably with tax cuts in Germany, and giving the European Investment Bank a huge capital increase to lend to companies in southern Europe, he said.
Using the EIB to inject the equivalent of 2-3 percent of gross domestic product a year into south European economies for a limited number of years would be the most effective and politically feasible way to revive growth, Darvas said.
No such plans are under consideration in the European Union, and German, Dutch and Finnish voters remain deeply hostile to any fiscal transfers to southern Europe.
With Germany facing its own general election in September, followed by the usual period of coalition negotiations, it is hard to imagine any major policy shift this year.
EU growth initiatives so far have been on a far more modest scale, including a small boost to EIB capital last year and a recently created 6 billion euro youth employment fund due to take effect next January to support job training and mobility.
Monti warned repeatedly last year that anti-European populists would gain ground in the south unless the euro zone did more to support his efforts and those of Spanish Prime Minister Mariano Rajoy by bringing down borrowing costs.
Those costs did fall significantly after the ECB announced its bond-buying initiative in September, but Monti's appeal for more financial solidarity from Germany fell on deaf ears.
Whether his election debacle, after European leaders encouraged him to enter the race, will sway minds in the EU remains to be seen.
For the moment, their key priority is to help Ireland and Portugal return to capital markets later this year to demonstrate success for their bailout and adjustment programs.
French Finance Minister Pierre Moscovici, also speaking at the Reuters Summit, was one of the rare voices to say the Italian voter backlash showed that austerity had gone far enough and it was time to strengthen growth.
His German counterpart, Wolfgang Schaeuble, a leading advocate of austerity during the crisis, drew no such lesson, saying European policies were not to blame for greater inequality and economic divergence between north and south.
"We need to continue on this path, but we will have setbacks," Schaeuble said.
It may take another, bigger jolt than Italy's election to spur euro zone leaders to change course, if they ever do.
(Writing by Paul Taylor; Editing by Jeremy Gaunt)