Pressure in the Core: Dutch Treat

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Business Insider

To the extent there is much investor concerns about the core of the euro area it has tended to focus on the French elections, where the Socialist challenger Hollande has been particularly provocative in his campaign rhetoric. He has called for a dramatic increase in taxes on the wealthy and insists on renegotiating the recently approved fiscal pact.

Weekend reports, subsequently denied, that Germany and several other countries would not officially host Hollande. The election has also seen French President Sarkozy's star dim in Europe as he is lagging in the polls and this appears to be impacting his rhetoric as well.

However, developments in the Netherlands may steal the limelight as the French election is still more than a month away. The key issue in the Netherlands is that last week, the Dutch Bureau of Economic Policy Analysis warned that next year's deficit will exceed the 3% target.

This has the potential of triggering a political crisis. The overshoot is going to require more austerity measures and the governing coalition may not survive.

In particular, the Dutch Freedom Party, the smallest of the three parties in the governing coalition, is a populist party that is openly hostile toward monetary union. It has called for the Netherlands to leave the monetary union.

It commissioned Lombard Street Research to do a cost benefit analysis and that is due to be published Monday. However the details were reported over the weekend and they show a net benefit of dropping out and reintroducing the guilder. The costs associated would be recouped, theoretically, within two years.

It is not so much that this is a realistic possibility, but the point in this context is that the Freedom Party is unlikely to support more austerity measures to comply with the EU. Prime Minister warned that 16 bln euros in new savings are needed. The Dutch economy began contracting in H2 2011 and is expected to shrink through the first half of this year (at least).

There has been little market response to these developments and the looming risk that the government falls. Today's bond auction was well received and the 10-year benchmark has kept pace with Germany since news first broke in the second half of last week. The price of the 5-year CDS has risen in recent days, but remains at the lower end of its 6-month trading range.

We bring this to your attention, not because there has been a market reaction, but because there hasn't been one. It illustrates how the core, or at least some of the core, is being impacted by the austerity agenda. The political fallout is also not limited to the periphery.