Europe faces electoral and policy crossroads

By Mike Peacock

(Reuters) - The threat to its survival may have passed but the euro zone faces electoral and economic crosswinds this year which could push it to break policy taboos while challenging its ability to do so.

The threat of deflation is stalking the currency area and increasing pressure on the European Central bank to act.

Anti-euro parties look set to perform well at elections to the European parliament in May and could hamper the bloc's ability to enact measures to bind its member states together more closely.

Euro zone leaders are still struggling to generate solid economic growth that can eat away at unemployment rates running at 25 percent and more in the hardest hit countries, and efforts to create a banking union to prevent a future financial crisis are widely viewed as having fallen short.

The bloc will also try to get Portugal and Greece back on their feet after Ireland successfully exited its EU/IMF bailout. Athens is likely to need more help to do so.

Italy remains a potential flashpoint. Efforts to reform its electoral law to allow for a more stable government in future, one that can push through much-needed economic reforms, will be critical for it and the euro zone this year.

French President Francois Hollande's ability to push through his own labour and pension reforms in the face of rock-bottom popularity ratings is also a focus.

Then there is the question of Britain's place in the EU. Prime Minister David Cameron has promised an in-out referendum in 2017 and is seeking to renegotiate Britain's terms of membership first. There is little sign that his EU partners are willing to play ball.

All this and more will be addressed at the annual Reuters euro zone summit, from February 10-13, which features a host of finance ministers, prime ministers, central bankers and Brussels-based policymakers.

The latest threat to the euro zone is the evaporation of inflation. Japan's lost decade is a vivid reminder of what could be at stake and that the only cure may be printing money, a difficult pill for the ECB to swallow.

The ECB left rates at a record low 0.25 percent last week but President Mario Draghi signalled that its next meeting in March might be a different matter. By then, it will have fresh forecasts for growth and inflation and if they are lowered, action could follow.

Draghi insists deflation is not in prospect but if the latest bout of emerging market turmoil persists, that could well push the euro higher and exert further downward pressure on prices.

"More aggressive actions aimed at addressing deflationary risks may eventually come. But this would entail a shift in the ECB's macroeconomic outlook," said Huw Pill, chief European economist at Goldman Sachs. "Such a shift requires time, both to accumulate evidence and to build consensus around a new view."

ELECTORAL TEST

High unemployment, austerity fatigue and paltry growth offer the perfect backdrop for fringe parties to prosper at the EU elections in May.

Some pundits predict a group of anti-euro parties including the National Front in France, Britain's UKIP and the Dutch Freedom Party, along with Greece's anti-austerity party Syriza, could capture 20 percent or more of the seats.

That could pressure the European Union's main party groups to tack right and challenge Europe's ability to integrate further, given new powers the parliament will have to rule on the majority of EU legislation.

The electoral arithmetic may well turn out to be different and it is true that these parties disagree on much more than they agree. But the experience of political gridlock in the United States looms large.

"Just think of how the Tea Party has made governance difficult in the U.S.," Axel Weber, UBS chairman and former Bundesbank president, told the Davos forum late last month.

One of the fringe parties that could benefit is Britain's UKIP which wants nothing less than EU withdrawal, a view that chimes with some in Cameron's ruling Conservative party.

The British government is intent on opting out of parts of its EU obligations and then have a case to stay in. Only with that can Cameron hope to unite his party behind him - and maybe not even then.

When the euro debt crisis was raging, there was an acceptance that the EU Treaty might need to be changed to build in new bulwarks to keep the bloc together. Within that process, London spied an opportunity to obtain concessions of its own.

But now the appetite for complex treaty renegotiation has faded. French President Francois Hollande told Cameron bluntly last month that it was no longer a priority.

(Editing by Robin Pomeroy)

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